The One Thing Bernanke Must Not Do Tomorrow

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A "coin toss." That's how most economists describe the outcome of this week's Federal Reserve meeting and the decision on whether to start slowing its asset purchases tomorrow or wait until early next year.

From an economic point of view, it matters very little whether the Fed cuts its $85 billion monthly bond-buying program now, in January or in March. Most folks expect the first reduction to be modest anyway, on the order of $10 billion or $15 billion.

What matters is the optics. The Fed can taper tomorrow or decide to wait for more data before it proceeds. But the one thing Chairman Ben Bernanke must not do is talk the taper for next month unless he is positive he can walk the taper when the time comes. The Fed's credibility is at stake, especially because it relies on forward guidance as a policy tool.

Bernanke started laying the groundwork for scaling back bond buying in May. At hisnews conferencein June, he offered a timeline: If the data are consistent with the Fed's forecast, tapering could start "later this year." In September, he balked. Forward guidance is only as good as the ability to follow through. Remember "The Boy Who Cried Wolf"?

Recent economic reports have been decidedly upbeat. Inflation, however, is still well below the Fed's 2 percent target. The will to taper may be there, but the urgency is lacking.

The Fed has been relying on forward guidance to prevent long-term interest rates from rising. In a typical business cycle, the funds rate rises as the economy gathers steam. This is no ordinary business cycle. The funds rate has been close to zero since December 2008. The recession ended in June 2009. Based on the Fed's most recenteconomic projectionsfrom September, only three of the 17 current members of the policy-making committee expect the first increase in the funds rate to occur before 2015.

Once the Fed starts tapering and presumably outlines a plan for winding down monthly asset purchases -- data-dependent, of course -- financial markets will have to find a new obsession. If the recent data are truly reflective of a trend, it won't be too long before the Fed's forward guidance on the funds rate gets a run for its money.

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