Friday, February 22, 2013

El-Erian FT Comment

Here is my response to a commentary in the FT today by the "A-Lister", Mohammed El-Erian, which you can read here.

What Mohammed fails to recognize is that the Fed's actions are difficult to reverse without creating either a "shock" or a longer terms "dampening" dampening effect on economic growth. In short, they have unintentionally boxed themselves in.

In particular, the Fed is now heavily invested in the government bonds and mortgage backed securities, so in fact if sequestration happens (or some more comprehensive "can-kicked" compromise later this year), then the Fed can start to unwind it's operation twist and bond position as it's presence will no longer be essential to support fiscal policy stimulus. What will be left though is the Fed's underpinning of the housing sector, which it has now (mistakenly in my view) made its "quasi" monetary policy instrument linked to an unemployment rate target.

This puts the Fed in a very awkward position though - as if sequestration goes through, then although the Fed's government bond purchases can be unwound, if the expenditure cuts cause a shock to the real economy, what does the Fed do? Obviously some might say it should stimulate the housing sector by increasing it's purchases of mortgage-backed securities, but that i) may start pumping air into a housing bubble again and ii) have little effect on the rest of the real economy if smaller new houses look less attractive than older houses thereby dampening the employment effect of the stimulus.

All I can say is that I'm glad I"m not on the FOMC at this time!! 

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