On the upswing.

Photographer: Andrew Harrer/Bloomberg

Fed Signals Tightening, Loosely

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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The Federal Reserve Board's comments today support the view that the rate-increase cycle it intends to embark on will constitute the loosest tightening in its modern history: an uncertain start, a shallow path and a terminal point below historical averages. The reasons for this are both domestic and foreign; and the longer-term implications are unusually uncertain.

The Fed is concerned about the slow U.S. economy. This worry was highlighted by the release today of data showing surprisingly weak growth of 0.2 percent for the first quarter of the year. The concern has both internal and external components.

On the domestic front, the appetite for economic risk-taking of U.S. companies remains low, particularly when it comes to investing in new production capacities and equipment. That stands in stark contrast to the enthusiasm for risk-taking in financial markets. Consumers have been hesitant to use the dividend they received from lower oil prices to increase their spending on other goods and services. And exports have suffered from the appreciation of the dollar since last summer. All this has been accentuated by the negative impact of transitory factors in the first quarter, including bad weather and port closures.

The external picture remains fluid, as unsteady economic conditions are accompanied by risky geopolitical trends and national politics. Europe is dealing with the Greek crisis, again. Japan has yet to implement fully the structural reform component of its "three arrows” program of economic recovery. And, in the emerging world, countries such as Brazil and Russia still face downside risks while China is unable to resume its role as a locomotive for global growth.

Against this background, the Fed's statement today is consistent with the idea that the central bank, after more than six years of rock-bottom interest rates, will act with particular caution to raise them. 

The timing of the first rate hike is quite uncertain. By removing calendar references from its forward policy guidance, the Fed left on the table the (highly unlikely) possibility of a June increase. Its real objective, however, is to retain considerable flexibility, confirming that its decisions are strongly data dependent. The most likely start date is September, though even that is subject to uncertainty.

Forward Guidance

Once the increases begin, the Fed would work hard to convince the markets that the pace of subsequent hikes will be slow, hesitant and subject to course correction. In doing so, it would be trying to counter the markets' traditional behavior of pricing in the rates that would prevail at the end of the cycle. As a result, the forward policy guidance is also likely to place future stress on a rate destination that is below historical averages.

All this makes sense for two important reasons. First, although growth is likely to recover and end the year closer to a 2.5 percent to 3 percent annual pace, both demand and supply impairments will hold back the stronger recovery that the economy could have had and will continue to raise concerns about potential output. Second, inflationary pressures are likely to remain muted for quite a while.

The Fed's dilemma is elsewhere. A tightening policy that is too loose could make it difficult to prevent the kinds of excessive financial risk-taking that would be disruptive in the absence of materially stronger growth. This concern is amplified by the widespread market illusion of liquidity: the belief that liquidity will be available to allow overexposed investors to reposition at reasonable prices and with appropriate timing in the event of a market shift. Due to both regulatory and market forces, the risk-absorption capabilities of broker-dealers are likely to fall short of what end investors believe are necessary and have been used to.

As much as the Fed would like to get conditions back to normal, this isn't going to happen anytime soon. When this exceptional period of rock-bottom interest rates eventually starts to end later this year, what's likely to follow will be an equally experimental and unusual hiking cycle.

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

To contact the editor on this story:
Max Berley at mberley@bloomberg.net