The minutes released Wednesday by the Federal Reserve are a must-read for those interested in the complexity of modern central banking--if only for the striking contrast between the milquetoast discussion of the economy and the many policy and market complexities.
There is little that is new or noteworthy in the sections on economic developments and prospects. The bottom line is also a repeat of what has characterized many post-global financial crisis minutes: a more muted immediate economic outlook (growth and inflation) coupled with somewhat greater optimism for the longer term--all on a baseline characterized by the usual references to "modest," "moderate" and "cautious."
By continuing the practice of compensating for a somewhat softer short-term outlook with upward adjustments thereafter, the FOMC is sidestepping an issue that has now entered the mainstream lexicon with a bang because of recent remarks by Larry Summers and Paul Krugman. It's what's being called "secular stagnation" and what Pimco in 2009 labeled the "new normal"--namely, a prolonged period of low growth and persistently slow job creation.
The minutes' rather subdued economic discussion contrasts with the large number of open policy (and therefore market) questions.
From the interaction between the two main tools (asset purchases and forward policy guidance) to the consideration of new ones (lowering IOER), and from how and when to taper to the best way to communicate with markets, the minutes paint a truly complicated policy mosaic.
Further, it is one that is still in the making and whose ultimate shape--and therefore impact--is subject to considerable uncertainty.
The complexity also extends to the specification of the intermediate policy targets that are so crucial for fine-tuning the policy response and thus delivering desired outcomes. Specifically, Fed officials posed the legitimate question of whether the commonly followed unemployment rate overstates the improvement in the labor market and, probably more controversial, whether it makes sense to add an inflation floor.
Finally, the minutes suggest that this is a Fed that is contemplating not only what could go right if it continues on the current policy path but also what could go badly wrong.
For this reason, officials "considered scenarios under which it might, at some stage, be appropriate to begin to wind down the program before an unambiguous further improvement in the economic outlook was apparent." Why? Because of "concerns about the efficacy or costs of further asset prices."
Such complexity can paralyze market participants at a time when the Fed in particular and central banks in general continue to play an important role in asset price determination. Yet some aspects are less ambiguous.
Taken in their entirety, the minutes provide further support for a consequential hypothesis: As part of a forthcoming policy evolution, the Fed wishes to encourage markets to delink their assessment of the two main policy tools--thereby enabling Fed officials to strengthen forward policy guidance, reduce (very gradually and carefully) heavy reliance on balance sheet operations and avoid a repeat of the May-June disruptions to the functioning of markets.
Fed officials may even be tempted into cutting IOER as a way to help manage this tricky and uncertain policy pivot.
This is the reason why Pimco stresses greater differentiation in portfolio positioning.
We have been favoring the front end of interest rate curves while shying away from the long end--a point that my colleague, Bill Gross, has stressed repeatedly in his writings and tweets. It is also why, given current price levels, we feel that risk assets are becoming consequentially more dependent on a proper recovery in fundamentals and not just continued policy support.
And it is why we believe that greater attention should be devoted to recent disparities in performance among and within some major asset classes.
Mohamed El-Erian is CEO and co-chief investment officer of Pimco, a global investment management firm.
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