Column: Fed’s surprise and Yellen’s challenge

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SummaryThe question should be about Fed's policy effectiveness, not what Janet Yellen has in store for US monetary policy

The US Federal Reserve sparked a global—and now month-long—guessing game with its decision on September 18 not to “taper” its monthly purchases of long-term securities. The Fed does not surprise markets often, and this has been especially true of the Ben Bernanke-led Fed, which has devoted enormous time and effort to better communication, greater transparency, and timely management of expectations. Now that President Barack Obama has nominated Fed vice-Chair Janet L Yellen to succeed Bernanke in January, there is even greater interest in what lies ahead for the world’s most important central bank.

To be sure, Fed officials did not do a great job of managing expectations in the weeks preceding their September policy meeting. Having also struggled to reclaim the narrative thereafter, there is great interest in understanding what led the Fed to act in such an uncharacteristic manner. Nonetheless, the real issue is that the Fed’s last-minute change of heart does not significantly alter the main challenge that the highly-qualified Yellen will face: persistently weak economic fundamentals and doubts about the continued effectiveness of the Fed’s policy tools.

Five main arguments for the Fed’s decision to postpone the taper have frequently been proposed. One view is that the Fed recognised that its specification of policy thresholds (based on the unemployment rate) understated the vulnerability of the US labour market. Another is that officials worried about excessive financial tightening after Bernanke’s mention in May of a possible taper, jeopardising the economy’s gradual recovery.

Moreover, some believe that the Fed considered the possibility of adverse feedback loops associated with the financial dislocations in emerging economies. Others see in the decision to postpone the taper an effort to pre-empt the negative effects on the economy of a possible congressional debacle over government funding and the debt limit. Indeed, the final argument—in a sense underpinning the others—is that the Fed became less worried about the potential for collateral economic damage from prolonged reliance on unconventional monetary policy.

The first three arguments speak to the Fed’s heightened concerns about the economy in general, and about the labour and housing markets in particular. The fourth reflects a desire to insure the economy against congressional dysfunction. And if the Fed feels that the costs and risks of hyper-activism have indeed diminished (the fifth argument), it becomes more comfortable maintaining intense policy experimentation.

Most of these arguments—though not all of them—have merit. That is the good news. The bad news is

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