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ANALYSIS: In the wake of the financial crisis, the U.S. Federal Reserve has undergone a slow transformation in the way it conducts monetary policy -- and nowhere was that more evident than in this week's bold announcement tying the central bank's actions to improvements in America’s struggling labour market.
Along with its decision to tie its actions to the labour market -- which Fed chair Ben Bernanke recently called a "grave concern" -- the central bank agreed to purchase $40-billion US a month of mortgage-backed securities and pushed out its forecast for a zero interest-rate policy until 2015.
"The idea is to quicken the recovery to help the economy begin to grow quickly enough to generate new jobs and reduce the unemployment rate," Bernanke said in a press conference on Thursday.
But it didn't stop there. The Fed also opened the door to an unlimited amount of bond-buying, dubbed Quantitative Easing (QE) by investors, and other programs.
"If the outlook for the labour market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability," the Fed said in a statement announcing its decision. "In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases."
This is new territory for the Federal Reserve. Never before has the U.S. central bank tied its actions specifically to the labour market and it shows it may be putting inflation concerns on the backburner until the economy starts producing a healthy serving of new jobs.
This comes after a number of first-time moves by the Federal Reserve this year which saw it announce an established inflation target -- where before that target was informal – and more transparent communication policies, such as including its members' views on monetary policy and future interest rate levels.
Investors reacted positively to the new round of intervention by the Federal Reserve, pushing equity markets higher, as well as prices for commodities such as gold and oil.
But some economists are concerned about the new look of the Fed, saying it's going to be difficult for the central bank to eventually wean the market off its support. They also question whether bond purchases would help the economy recover from the financial crisis.
"The Fed has clearly made its exit strategy more complicated, which in turn will result in a continuation of higher inflation expectation and curve steepening. We continue to call into question the ultimate efficacy of further QE measures and therefore the need of the program, as the cost/benefit analysis does not warrant another program at this time," Adrian K. Miller, director of global markets strategy at GMP Securities, said in a note to clients.
Others question whether the Fed should consider the track record of its previous bond purchases before doing more.
"Since the earlier QE1, QE2 and Operation Twist programs were not accompanied by a satisfactory rate of improvement in labour market conditions," says Maury N. Harris, an economist at UBS. "Why should investors think the most recently announced Fed policy steps should have any better success?"
The Fed's decision to essentially open the door for an unlimited amount of bond buying also carries its own risk. Capital Economics' Paul Ashworth says that while the Fed has done everything the market asked for, it is also spurring investors to speculate on further action.
"The problem is that we doubt it will be enough to get the economy on the right track. It's only a matter of time before speculation begins as to when the Fed will up its Mortgage-Backed Securities purchases from $40 billion a month and/or add Treasury securities net purchases to the mix," he says in a note to clients.
But not everyone is lashing out at Bernanke and Co. Some economists are cheering the central bank's bold actions, saying it's exactly what is needed to help lift the U.S. economy out of its current funk and prevent it from slipping back into recession.
"My view is that this is a courageous move by the Fed and I applaud it. Rather than politicizing the Fed, it proves they are independent and willing to do what they believe is right regardless of the political fallout," says BMO's Sherry Cooper "No doubt, they will come under tremendous criticism from politicians and others; but Bernanke has already shown himself impervious to these outside pressures and willing to pursue this path."
But one of Ben Bernanke's toughest critics may be a fellow academic economist -- Michael Woodford, an economics professor at Columbia University and one the country's leading macroeconomists.
In a paper presented at the Jackson Hole conference in August, which has garnered significant buzz, Woodford called into question the Federal Reserve's move to provide forward policy guidance, as well as its bond-buying programs.
Woodford said the Fed -- rather than simply providing what it predicts its interest rate will be in the future based on current information -- should instead tie its interest rate policy to nominal GDP, a measure of spending on goods and services that doesn't consider inflation. He says that doing so would allow the central bank to keep interest rates at zero as long as the economy remains below a pre-determined target of nominal GDP.
He says America’s nominal GDP is currently below its trend-rate prior to the financial crisis. By ensuring low interest rates until nominal GDP moves higher than what would be normally accepted under the Fed's two-percent inflation target allows the central bank to stimulate the economy to a larger extent than under its current policy.
Woodford also questions the effectiveness of the Fed's previous rounds of quantitative easing.
"The even more massive increases in the monetary base by the Federal Reserve’s unconventional policies since the fall of 2008 have similarly had little evident effect on aggregate nominal expenditure," he said in his paper.
Woodford's arguments may already be having an impact on how the Fed conducts its business, as Bernanke cited his paper at his press conference and the economist welcomed the new moves by the Fed.
"The uncertainty about how things might be unfolding next is one of the biggest obstacles to the economy improving. So how you affect perceptions is really critical at this point to what they're trying to do," Woodford said.
Unlike the Fed's first two rounds of quantitative easing, in which it bought about by $2.3 trillion worth of securities, Woodford argues that the plan unveiled on Thursday would not give the impression that the central bank has grown more pessimistic about the economy.
The central bank's new strategy assures individuals, businesses and investors that it is committed to both act, and then to shut down its unconventional policy actions when the time is right, Woodford said.
"They're making bad news less destabilizing in one direction, and making really good news less destabilizing in the other direction," he said.
With files from Reuters