Taper, or not taper?

Yesterday the Federal Reserve, the US central bank, announced to world markets its intention to keep pumping out large quantities of cash. Quantitative easing, as it is called, would continue. A statement by the Fed, issued after a meeting of its Federal Open Markets Committee, said that: “the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40bn per month and longer-term Treasury securities at a pace of $45bn per month.”

This announcement came as a huge relief to global markets, which surged on the news. Earlier this summer Ben Bernanke, the Chairman of the Federal Reserve, had indicated that the Fed’s quantitative easing programme would be reduced, or in his word “tapered” (where do economists get their jargon?) and his message sent a chill through the global economy.

Even though Lehman Bros collapsed more than five years ago, the consequences of the ensuing global crash have not passed. Global growth is weak and liable to stall. The steady flow of cash from the Fed into the global economy has helped to buoy up global markets—as one commentator has said, QE is the “only show in town.”

The Fed’s decision was a surprise. The assumption that QE was going to be scaled back had begun to manifest itself in rising bond yields, in the US and elsewhere. This deterioration was acknowledged in the Fed’s statement as the reason for which the taper was deferred: “the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market.”

So what has happened here? The largest, most powerful global central bank in the world—the Fed—announced that it was going to tighten its purse strings and the reaction to this was a cooling of economic conditions. However, when the moment came to act, the Fed cited the very economic cooling that its announcement had generated as its reason for not acting.

What this amounts to is a lesson in the dangers of central banks issuing “forward guidance” of their future intentions. Bernanke has tried it here and the result was a severe market distortion that caused him to change his plans. Mark Carney, Governor of the Bank of England, should take note.