What will emerge from next week's meeting? 

Here's What the Fed Will Do

Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”
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Interest in next week's two-day Federal Reserve meeting has intensified after last week's extreme market gyrations. And views are quite diverse on Wall Street about what is likely to emerge.

When it first gave the timetable for an orderly exit from its third round of quantitative easing, the Fed hoped it would complete the final step this month amid a stronger economy -- one with fundamentals that would also make markets a lot less sensitive to every utterance from Fed officials.

Instead, the economy has yet to attain liftoff and, judging from last week's financial excitement, the asset-price linkages between markets and the Fed are still in play.

In this context, some feel that with last week's disruptions also undermining liquidity even in the most liquid of financial markets (that for U.S. Treasuries), the Fed has no choice but to surprise markets by being dovish -- by slowing its exit from QE3 and hinting at a subsequent QE4.

Others disagree, noting that yet another major flinch by the central bank in response to market volatility would merely aggravate underlying imbalances and unhealthy dependencies. Moreover, markets have bounced back from last week's selloff, and the most recent data confirm that the economy continues to heal.

I think the Fed will try to strike a balance between these two views. Here is how it will try to do that:

1. Fed officials will slightly upgrade their assessment of economic prospects. But their enthusiasm will be moderated by renewed concerns about global economic weakness.

2. They will acknowledge the further decline in the unemployment rate, while also noting that it overstates the improvement in labor market conditions.

3. They will recognize the moderation of inflationary pressures but hold back on declaring deflation an imminent threat to economic well-being. Instead, they will observe that part of the downward pressures on prices -- coming from lower oil prices -- provides both a boost to consumer spending and offsets higher food costs.

4. They will complete the phased exit from QE3, bringing large-scale purchases of securities to an end.

5. Finally, central bankers will shy away from hinting that they are willing to consider a subsequent program of asset purchases (QE4). Instead, they will reiterate their willingness to keep interest rates low, should economic conditions warrant it.

In doing all this, Fed officials will again try to buy time -- both for the economy to heal and for politicians to step up to their responsibilities -- hoping for better times ahead. And in finalizing the exit from quantitative easing and offering assurances about its future interest-rate policy, they will sidestep the issue of how this pivot to full reliance on just "forward guidance" might reduce the overall effectiveness of monetary policy.

Two additional issues will remain obscure until the release of the more detailed minutes of the meeting. First is the extent to which views are diverging even more within the Fed's policy-making committee as the economy approaches a tricky inflexion point; and second is what progress is being made on how to raise interest rates when the time finally comes for that.

With a more decisive approach still eluding Fed officials, and understandably so, their immediate focus will remain on enhancing policy options, avoiding a short-term mistake and reducing the risk of a market accident. In other words, the Fed will again seek to muddle through a complicated situation.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Mohamed Aly El-Erian at melerian@bloomberg.net

To contact the editor on this story:
Katy Roberts at kroberts29@bloomberg.net