The Marriner S. Eccles Federal Reserve Board Building (commonly known as the Eccles Building or Federal Reserve Building). Photo by AgnosticPreachersKid (Own work) [CC-BY-SA-3.0 (http://creativecommons.org/licenses/by-sa/3.0)], via Wikimedia Commons
The Marriner S. Eccles Federal Reserve Board Building (commonly known as the Eccles Building or Federal Reserve Building). Photo by AgnosticPreachersKid (Own work) [CC-BY-SA-3.0 (http://creativecommons.org/licenses/by-sa/3.0)], via Wikimedia Commons

Not yet, at least.

The big news this week in global financial markets was the Federal Reserve Board's decision not to begin a much-anticipated "tapering" of its large-scale purchases of assets —"quantitative easing," or simply QE as it is known. Prior to the announcement Wednesday, the balance of opinion was heavily tilted to the side of those who believed that, with prospects for the U.S. economy looking better, particularly a slow, steady decline in the unemployment rate, the Fed would begin to dial back on its asset purchases. The decision not to begin tapering was met with an exhuberent response in asset markets.

The Fed began purchasing assets in the wake of the global financial crisis when it was feared that, with interest rates already at very low levels (the so-called zero-lower bound), its ability to promote economic recovery could be impaired. With nominal rates at zero, an increase in the rate of deflation would imply higher real interest rates (nominal rates adjusted for inflation)and a tightening of monetary conditions. That would result in higher unemployment, greater slack in the economy, and still higher deflation. The threat of a dangerous downward spiral of the economy could not be discounted and that threat dictated that extraordinary actions be taken.

Almost from the start, however, there were concerns that quatitative easing entailed risks. The fear, expressed by some, was that it would lead to the debasement of the currency and a Weimar-like hyperinflation. Needless to say, such fears have not been realized; as calmer voices pointed out, the possibility of inflation was remote in an economy suffering from a large output gap. Yet, over time, as the economy improved and the longer the extraordinary measures remained, observers warned, the greater the risk of temporizing with inflation. 

Such thinking led markets and the bulk of informed opinion to conclude that the Fed would indeed announce the start of a tapering down of asset purchases.

Why did "concensus" get it wrong?

First, although Fed chairman Ben Bernanke had earlier signalled a possible tapering of quantitative easing as early as September, the response of financial markets was so sudden, swift and severe that it undoubtedly gave him pause. The gradaul reduction of QE should only done in the face of sustained strength of the economy. In this respect, while the unemployment rate has come down significantly from the post-Lehman high, it has done so, in part, because labour market participation rates have not recovered: things have improved, but the chairman knows that there is more room for improvement before inflation becomes a serious threat.

The second possible reason why the Fed frustrated the expectations of informed opinion is the uncertainty that continues to cloud economic prospects. In the five years since the Lehman shock, the global economy has been powered not by the advanced developed economies of the G7 but the emerging and developing economies of Asia, Africa and Latin America. The pivot of global growth exposed by the global crisis is truly remarkable. Moreover, this pattern is welcomed as, in most cases, it reflects improved policy frameworks and the growth that underlies it can lead to sustained poverty reduction. Lately, however, signs of weakness have appeared. There are, for example, growing concerns about the sustainability of Chinese growth; such worries are magnified by the accumulation of debt fuelled by shadow banks. Elsewhere, concerns have been voiced that the benefits of growth have not been shared equally.

Regardless, in the face of these uncertanties, the Fed has to balance risks of tapering of quantitative easing in a less favourable global environment. For the avoidance of doubt, this is not an argument that the Fed has "seen the light" and is incorporating external effects into its decision making (or "objective function" in the jargon). It is, rather, a recognition that, in the hyper-connected global economy of the 21st century, Fed chairpersons may not, as their predecessors did, assume that the U.S. is a virtual closed economy.

At the same time, the Fed may be grappling with another uncertainty stemming from domestic policy-making. As summer turns to fall, attention once again turns to the prospect of a fiscal cliff and the uncertainty that a debt ceiling and dysfunctional political process presents to global markets.

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