Mohamed El-Erian Explains:
Here are a few pointers as we all get ready for another highly-anticipated meeting of the FOMC, the Fed’s most important policy making committee.
The institutional context: This week’s FOMC meeting is of interest for more than its update of economic developments and prospects, policy insights and actions, and the periodic release of the summary of economic projections. It is the first FOMC meeting to be chaired by the highly-respected Janet Yellen; and it will be her first press conference as the leader of the most powerful central bank in the world.
The Policy Context: Absent some major economic acceleration or deceleration – and, I stress, it has to be major, one way or the other – the FOMC is essentially on automatic pilot for 2014. Specifically, the Fed will:
- Leave policy rates as is;
- Continue to taper in a gradual fashion with a view to fully exiting QE3 by the end of the year; and
- Evolve and strengthen its forward policy guidance.
The Economic Context: The FOMC’s approach is underpinned by the view that the underlying economic conditions are strengthening, albeit slowly; that balance sheets continue to heal; and that inflation is well contained (maybe too low). As such, senior Fed officials would attribute most of the recent weakness in economic indicators to the temporary and reversible impact of the weather. And the situation in the Ukraine would be seen as important to monitor but not a reason for a policy course adjustment.
The Intrigue: As it pivots from balance sheet purchases (QE) to greater reliance on forward policy guidance to support the economy, there are significant uncertainties as to how the Fed can/should best do this – particularly when it comes to the forward guidance component. What we know for sure is that the Fed will transition away from its current (narrow) unemployment threshold to a more holistic view of the labor market. This could even happen as early as this week. We don’t know as yet when our central bankers will supplement this by an inflation indicator that is well above the current rate. This is relevant for markets as investors would take the latter as an even stronger signal that the Fed would remain on hold for quite a while. If not, markets would be much more willing to test the central bank.
The Immediate Market Implications: Assuming other things are relatively constant (and that is a big assumption given what is happening in Ukraine and some other emerging economies), risk assets would do well if the Fed does indeed decide to evolve its forward policy guidance by moving both on the unemployment and on the inflation fronts – that is to say, inserting more comprehensive employment indicators and some type of inflation target. Also, in such circumstances, the dollar would weaken against other major currencies, inflation-protected bonds would do well, and the nominal Treasury yield curve would steepen.
The Big and Consequential Uncertainty: Notwithstanding the Fed’s continued activism and vigilance, and despite its deep and steadfast commitment to support growth and jobs, there are unanswered questions about the overall effectiveness of its current policy stance. The concern – for both Main Street and Wall Street – is that the longer the Fed experiments and the longer the economy fails to attain “escape velocity,” the greater the likelihood that the durable benefits of its unconventional policies would be offset by the “costs and risks.” Look for this issue to assume greater prominence as the Fed shifts this year from directly impacting the net supply of securities (via its QE purchases) to indirectly influencing it (via strengthened forward policy guidance). In the process, markets would likely periodically test both the Fed’s resolve and its effectiveness.
So far, investors have repeatedly given the Fed the benefit of the doubt. And it has been the correct trade, over and over again. But if the economy continues to respond rather sluggishly, and with developments in the rest of the world now acting as headwinds, the Fed may have to experiment even more to sustain the wedge between market values and underlying fundamentals.
Mohamed A. El-Erian is the former CEO/co-CIO of PIMCO. He is Chief Economic Advisor at Allianz and member of its International Executive Committee, Chair of President Obama’s Global Development Council and author of the NYT/WSJ bestseller “When Markets Collide.”
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