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.

Flloyd Norris writes:   What happens when you turn over regulatory responsibilities to people who think there is really no need for regulation?

The United States, and much of the world, tried that for a large part of the last quarter-century. Along the way, a series of crises sent out warning signals that were not heeded.

After the economy recovered from the stock market crash of 1987, Alan Greenspan, the Federal Reserve chairman who had poured money into the market to stem the damage, was celebrated as a hero. He believed in what came to be derided as “market fundamentalism,” holding that markets were far smarter than governments and would produce optimal results if only there were no interference from politicians.

That analysis certainly seemed reasonable through much of the 1990s. The economy grew without a recession for 10 years, the longest such stretch in United States history. A few people worried that bad things could happen as a result of the explosive growth in derivative securities, but they were largely marginalized by the obvious fact that only good things were happening.  Financial Regulation

Peter Praet writes:  Konrad Adenauer, Germany’s first chancellor after World War II, famously said: “Why should I care about the things I said yesterday?”

We at the European Central Bank noticed that our monetary policy was no longer having the effect on private borrowing costs to which we were accustomed. It was obvious that the lending channels in the banking system had become dysfunctional; excessively restrictive borrowing conditions were suppressing demand. In response, the ECB did precisely what any central bank would have done: we acted to restore the relationship between our monetary policy and the cost of borrowing.

In June, we introduced a series of targeted longer-term refinancing operations (known as TLTROs) to provide funding for banks at very low fixed rates for a period of up to four years. Our programs to purchase asset-backed securities and covered bonds were tailored to help lower funding costs from banks to customers.

Together, these measures address the root causes of impaired bank lending,facilitating new credit flows to the real economy.
At the same time, inflation has continued trending down. In November, annual inflation in the euro area fell to a cyclical low of 0.3%, largely owing to the sharp fall in oil prices since the end of the summer.
Falling oil prices and the prospect of a prolonged period of low inflation also seem to have affected inflation expectations. Given the potency of the recent oil-price shock, the risk is that inflation may temporarily slip into negative territory in the coming months. Normally, any central bank would welcome a positive supply shock. After all, lower oil prices boost real incomes and may lead to higher output in the future.
That is why the ECB Governing Council has reiterated its unanimous commitment to use additional unconventional instruments within its mandate should it become necessary to address a prolonged period of low inflation, or should the monetary stimulus fall short of our intention to move our balance sheet toward its size in early 2012.

If we were to judge that the economy is in need of further stimulus, one option could be to extend the ECB’s outright asset purchases to other asset classes.

An important criterion for the choice of additional measures should be the extent of their influence over broad financing conditions in the private economy. For example, purchases of bonds issued by euro-area non-financial corporations (NFCs) would probably have some direct pass-through effect on firms’ financing costs.

It would be a different matter if we were to decide to buy bonds issued by euro-area sovereigns – the only market where size would generally not be an issue.

The effectiveness of interventions in the sovereign-bond market will also rest on the state of the banking sector. Higher capital ratios, lower exposure to bad loans, and more transparent balance sheets increase the chances that the ECB’s quantitative impulses will be transmitted to the wider economy.

That is why the completion of the ECB’s comprehensive assessment of banks’ balance sheets and the start of Europe-wide banking supervision will help revitalize sluggish lending in the euro area.

A decision to purchase sovereign bonds would also need tofactor in the institutional specificities of the euro area, including the limits set by the EU Treaty.

Mohamed El Erian writes:  The U.S. Federal Reserve is poised to take yet another step away from its extraordinary efforts to support the U.S. economic recovery. In doing so, it must strike a delicate balance between an improving recovery at home and a worsening outlook abroad.

Over the past several years, the Fed has relied on three main instruments to boost growth and generate jobs: extremely low interest rates, guidance on the probable future path of rates, and the bond-buying program known as quantitative easing. By lowering borrowing costs and pushing up the prices of stocks and bonds, the measures are supposed to encourage consumers to spend and companies to invest — hopefully before the potential benefits are overwhelmed by adverse side effects such as excessive risk-taking in financial markets.

After many fits and starts, the economic recovery is finally rising to the Fed’s expectations, allowing the central bank to start pulling back on stimulus. In October it stopped its program of quantitative easing. At its policy-making meeting this week, it will likely alter its forward guidance by removing a promise to keep interest rates floored near zero for a “considerable period” — a phrase the markets have taken to mean a minimum of six months. The change in language will set the stage for gradual rate hikes starting in mid-2015.

None of this should come as a great surprise. That said, investors need to recognize that the future of Fed policy is not set in stone. Fed officials will be navigating through a fragile global economy, buffeted by economic malaise in Europe and Japan and geopolitical tensions with Russia over Ukraine. With political gridlock rendering governments incapable of pushing through comprehensive measures to fully heal their economies, the task of reconciling economic and policy divergences falls to the currency markets, which will be challenged to do the job in an orderly manner.

As regards the destination, most agree that the Fed’s short-term interest-rate will likely end up below its historical average of about 4 percent. How much below depends on the central bank’s assessment of the structural factors weighing on the economy’s long-term growth potential. These include an aging population, insufficient infrastructure investment, inadequate education and fiscal policies — such as exemptions-ridden corporate and estate taxation — that inhibit growth and distort the allocation of productive resources.

For now, though, the Fed can continue bringing its policy back toward normal, albeit gradually, comforted by signs of broadening domestic economic healing.

William Pesek writes: As the world watches to see what Prime Minister Shinzo Abe does with his renewed mandate in Japan, my eyes are on Haruhiko Kuroda.  The Bank of Japan governor probably deserves about 90 percent of the credit for whatever success Abe’s reflation efforts have had including the 70 percent rise in the benchmark Topix index. Whether the prime minister now goes further and implements the real structural reforms Japan needs depends as much on Kuroda as anyone else.

Abe’s victory was not as sweeping as might appear at first glance.  Not surprisingly, officials in Tokyo are talking less about politically difficult reforms and more about putting money in the hands of Japanese to spend. Some think the Japanese are not ‘nudgeable.”

Analysts are expecting a rush of new fiscal stimulus early in the new year. Kuroda, too, will face pressure to one-up himself when the BOJ meets on Friday. Markets want the central bank governor to outdo his “shock-and-awe” from April 2013 and recent Halloween surprise on Oct. 31, when he boosted bond purchases to about $700 billion annually.

It’s time for Kuroda to do exactly the opposite: hold his fire and prod Abe to begin doing his part to push through his “third arrow” structural reforms. To this point, Kuroda has been a dutiful and circumspect policymaker — perhaps to a fault. Other than a brief flash of impatience with Abe’s foot-dragging when he said “implementation is key, and implementation should be swift” — Kuroda has held his tongue. Yet he bears a responsibility to play the honest broker role that monetary powers have over the years — from Paul Volcker at the Federal Reserve decades ago to Raghuram Rajan at the Reserve Bank of Inida today.

Now that the election is over, it’s up to Prime Minister Abe to carry out the will of the people and deregulate the economy.   A smart economist and wise tactician like Kuroda has to know this Japanese experiment will end very badly if Abe fails to encourage innovation, loosen labor markets, lower trade tariffs and cut red tape. If bond traders drive government bond yields higher and credit-rating companies pounce, the blame will fall squarely on Kuroda.

Some fear the apparent drift toward increased stimulus:  The investment world views Kuroda as a maverick — a man who’s breaking all the rules in Tokyo. In reality, though, he’s fallen into the same trap that ensnared the BOJ leader from 1998 to 2003 who pioneered quantitative easing.

Kuroda’s policies have indeed been bold — bolder than anything Abe himself has been willing to attempt. But the BOJ’s policies are allowing the government to sidestep its responsibility. That must stop if Abenomics is to come off life support. On Friday, Kuroda should begin nudging Abe to do something with his popular mandate for change.