Veering off course

Fed: The US Federal Reserve looks all at sea. The decision by the central bank’s Federal Open Market Committee to shift from keeping rates ultra-low for an “extended period” to the more definitively charted mid-2013 puts excessive faith in its forecasting power. Inflation, jobs and growth have already surprised the Fed this year. Locking in a course for two years as a sop to markets only makes it harder to navigate choppy waters.

The policy choice deepened a wedge between Fed Chairman Ben Bernanke and the committee’s most prominent hawks. They had already criticized previous efforts to reduce longer-term rates with last year’s $600 billion bond-buying program.

In a rare dissent for a group accustomed to consensus, the three regional bank presidents — Richard Fisher, Narayana Kocherlakota and Charles Plosser — disagreed with the latest move.

Committing to near-zero rates for two full years is risky, especially, given the Fed’s cloudy crystal ball. In the beginning of the year, it predicted the US economy would grow by 3.4-3.9 per cent in 2011, and saw inflation, as measured by the Fed’s preferred indicator, at 1.3 to 1.7 per cent and unemployment at 8.8-9 per cent.

All three economic variables are now outside those ranges and there’s little sign they’ll get back there. If the Fed can’t see out six months, surely the two-year horizon is too far off.

Previous Fed actions have been as unsuccessful as its forecasts. Its most recent bond purchases, known as QE2, may even have been counterproductive, as GDP growth slowed from 2.3 per cent to 0.4 per cent in the quarter after it was implemented. The recent stock market sell-off erased nearly all the post-QE2 gains.

Negative real short-term rates have encouraged the substitution of capital for labour and provided easy money for banks investing in long-term Treasuries, perhaps inhibiting the job surge that typically accompanies the recovery from a deep recession.

The Fed appears to have been trying to give companies, consumers and investors a little certainty in an increasingly uncertain market and economy.

But, the definitive nature of the rate decision also risks fueling inflation or encouraging prolonged stagnation. Either outcome would run counter to the Fed’s dual mandate. Worse, it suggests Bernanke’s crew is out of ideas and has been left to clutch at straws.