Steering locked

The US Federal Reserve could be setting itself up for an uncomfortable surprise. It extended its commitment to keep interest rates near zero, from about 18 months to three years on Wednesday. Job creation, departure of chairman Ben Bernanke or rising inflation could force a damaging reversal before then — or lead the Fed to drag its feet to avoid one.

In his press conference, Bernanke said with the Fed funds rate at zero, the US central bank had two means of affecting monetary policy, namely securities purchases and guidance. By pushing out the date when it expects rates to start going up from mid-2013 to late 2014, the Fed has potentially reduced yields on long-term paper.

Bernanke also outlined the Fed’s long-run goals and policy strategy, setting a soft inflation target of two per cent, based on the annual change in the price index for personal consumption expenditures. He noted a hard target would be incompatible with the Fed’s dual mandate, which includes promoting full employment as well as minimising inflation.

The US unemployment rate was 8.5 per cent in December, down 0.6 percentage points since August. Should that pace of improvement continue, unemployment would reach the Fed’s estimated “normal” range of 5.2 per cent to six per cent by mid-2013 — well before Bernanke’s new zero-rate end date.

Meanwhile, the PCE price index was up 2.5 per cent in November from the previous year. Given that’s already above the Fed’s soft target, it seems likely that inflation will rise sufficiently within the next three years to warrant an interest rate rise. Finally, Bernanke’s own term of office ends in January 2014. This year’s elections may determine whether he will get another term, and a different chairman could spearhead a very different policy.

Though the Fed’s 2014 date isn’t set in stone, an earlier reversal would damage its credibility. In addition, there could be a temptation not to deviate from its announced path, which might delay the needed interest rate increases for too long if unemployment or inflation trends demand them. In short, the Fed has roughly doubled the risk of being whipsawed by the market.