The Fed’s decision not to taper was a protest

But do they protest too much?

The Fed’s decision to surprise the market by NOT tapering last Wednesday was clearly intended as a protest at the market’s interest rate expectations and maybe also told us that now Larry Summers has been forced shamefully out of the contest, the front-runner to replace Mr Bernanke, San Francisco Fed President Janet Yellen, is already easing herself quietly into the Chairman’s seat.

The FOMC’s shock tactic certainly had the desired effect, sending Treasury yields tumbling and forcing estimates for the timing of the first Fed Funds hike further into the distance.

My guess, however, would be that this is will be brief victory for the Fed, and maybe ultimately a Pyrrhic one, endangering its credibility; the reason being that the Fed’s actions and statements are littered with inconsistencies.

The Fed’s own prognoses for the economy, the Summary of Economic Projections (SEP) would have us believe that by the end of 2016 the US will be enjoying an employment rate between 5.4 per cent to 5.9 per cent, very close to the FOMC’s own estimate for the long-run “full employment” rate which the economy can support without inflation getting out of hand, of 5.2 per cent to 5.8 per cent. However, extraordinarily, the SEP also tells us that inflation will be at or near the 2 per cent target, but that the nominal Fed Funds rate will still only be at 2 per cent (meaning the real rate will be near zero).

This set of outcomes would represent an unheard of state of affairs; for instance, the standard piece of theory used by economists to predict the appropriate level for interest rates, given prevailing unemployment and inflation rates, the so-called Taylor rule, would suggest a Fed Funds rate close to the long-run neutral level, which the FOMC itself estimates as 4 per cent!

When asked about these inconsistencies at the post-meeting press conference Chairman Bernanke said that “there may be possibly several reasons” for their end-2016 Fed Funds rate expectation being still far below the long-run neutral level but the “primary reason for that low value is that we expect that a number of factors, including the slow recovery of the housing sector, continued fiscal drag, perhaps continued effects from the financial crisis, may still prove to be headwinds to the recovery”.

Really? Eight years after the Financial crisis peaked? Why exactly? Show a little more faith in the US economy’s “animal spirits” please, Mr Bernanke but, hang on, your growth estimates for the next few years, with real GDP growth forecasts of 3.0 per cent in 2014, 3.25 per cent in 2015, and 2.9 per cent in 2016, are really quite upbeat? They don’t suggest that the crisis will still by then be inflicting the sort of structural damage that would call for the bizarre combination of economic variables and interest rates which you are trying to convince us will pertain?

My feeling would be that the Fed, like the BOE, will have to raise rates far earlier and faster than it would have us expect. Not tapering would have delivered an effective slap on the wrist to the market, the combination of the SEP and the forward interest rate guidance together meant “they did protest too much”.