Stephen S. Roach writes: America’s Federal Reserve is headed down a familiar – and highly dangerous – path. Consider the December meeting of the Federal Open Market Committee (FOMC), where discussions of raising the benchmark federal funds rate were couched in adjectives, rather than explicit actions.
The FOMC declared that it can now afford to be “patient” in waiting for the right conditions to raise the rate. Add to that Fed Chair Janet Yellen’s declaration that at least a couple more FOMC meetings would need to take place before any such “lift-off” occurs, and the Fed seems to be telegraphing a protracted journey on the road to policy normalization.
This bears an eerie resemblance to the script of 2004-2006, when the Fed’s incremental approach led to the near-fatal mistake of condoning mounting excesses in financial markets and the real economy.
The Fed has absolved itself of any blame in setting up the US and the global economy for the Great Crisis. It was not monetary policy’s fault, argued both former Fed Chairmen Alan Greenspan and Ben Bernanke; if anything, they insisted, a lack of regulatory oversight was the culprit.
This argument has proved convincing in policy and political circles, leading officials to focus on a new approach centered on so-called macro-prudential tools, including capital requirements and leverage ratios, to curb excessive risk-taking by banks. While this approach has some merit, it is incomplete, as it fails to address the egregious mispricing of risk brought about by an overly accommodative monetary policy and the historically low interest rates that it generated.
The Fed seems poised to make a similar – and possibly even more serious – misstep in the current environment. Given ongoing concerns about post-crisis vulnerabilities and deflation risk, today’s Fed seems likely to find any excuse to prolong its incremental normalization.
The Fed’s $4.5 trillion balance sheet has since grown more than fivefold. Though the Fed has stopped purchasing new assets, it has shown no inclination to scale back its outsize holdings. The persistence of extraordinary policy accommodation in a financial system flooded with liquidity poses a great danger.
Central banking has lost its way. Trapped in a post-crisis quagmire of zero interest rates and swollen balance sheets, the world’s major central banks do not have an effective strategy for regaining control over financial markets or the real economies that they are supposed to manage.
The longer central banks promote financial-market froth, the more dependent their economies become on these precarious markets and the weaker the incentives for politicians and fiscal authorities to address the need for balance-sheet repair and structural reform.
The unprecedented financial engineering by central banks has been decisive in setting asset prices in major markets worldwide. It is time for the Fed to abandon financial engineering and begin marshaling the tools they will need to cope with the inevitable next crisis. With zero interest rates and outsize balance sheets, that is exactly what they are lacking.
