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The immediate decision facing the Federal Reserve as it wraps up its regular policy meeting in Washington isn’t that momentous. The nation’s central bank will likely continue scaling back its support for the economy by reducing the long-term bonds it is buying by another $10 billion, following a path laid out more than six months ago.
But the bigger question is what’s at the end of that road. In the days leading up to the end of the meeting and Fed Chair Janet Yellen’s news conference on Wednesday, we’ll take a look at the debates that are shaping the central bank’s final destination.
Three lessons for the Fed from around the world
The U.S. central bank is not the only one confronted with an uneven economic recovery and a complicated exit from the aggressive policies adopted during the financial crisis. Several of the theoretical debates within the Fed are already playing out in real time in Britain, Sweden and Israel. Here’s what the central bank could learn from their experiences.
Bank of England
Like the Fed, the BOE has kept its benchmark interest rate at a historic low for the past five years. And investors across the pond are just as anxious as those in the United States over when the first hike might come. The difference is that BOE Gov. Mark Carney spelled out last week a scenario that Fed officials have taken great pains to remain mum about: Liftoff might come sooner than the markets think.
Unemployment in Britain has fallen much faster than the central bank expected, though Carney was careful to note there is still considerable slack in the labor market. But the country has also enjoyed stronger growth than expected. GDP has steadily risen over the past year and is now just 0.6 percent below its pre-crisis peak. The improving picture could nudge the BOE toward a rate increase sooner rather than later.
That has left Carney with the difficult task of prepping markets for an early move without inciting panic among investors that the central bank is snatching away the punch bowl -- a predicament that the Fed could soon find itself in as well. Judging from this speech last week, Carney’s strategy is to shift the focus away from the moment of liftoff to his assurance that the path of rate increases will be a gentle slope:
The MPC has rightly stressed that the timing of the first Bank Rate increase is less important than the path thereafter -- that is, the degree and pace of increases after they start. In particular, we expect that eventual increases in Bank Rate will be gradual and limited.
Both central banks have also emphasized that their decisions ultimately will depend on the economic data, in essence preserving their flexibility to change course if the recovery throws them another curveball.
Riksbank of Sweden
One of the most sweeping debates within the Fed is whether the central bank should ever use monetary policy -- that is, raise interest rates -- to combat financial instability.
Typically, concerns that banks or other financial institutions are taking excessive risks are handled through its regulatory arm. But some officials, notably former Fed governor Jeremy Stein, have argued that monetary policy can help pop nascent bubbles in corners of the markets that the central bank’s regulatory arm either can’t control or didn’t see in the first place. The risk is that such a move could slow down the economy and raise unemployment.
These are exactly the tradeoffs that Sweden is facing right now. The Riksbank began ratcheting up its key interest rate in 2010 amid concerns that households were racking up excessive debt. The central bank estimates that the average Swede with a mortgage owes 370 percent of his annual income. The International Monetary Fund has backed this “lean against the wind" strategy.
There is a cost to that stance, however: Unemployment stands at 8 percent, and inflation is well below the country’s 2 percent target. In fact, prices actually fell earlier this year. One of the bank’s most well-known officials, former Princeton University professor Lars Svensson, left the Riksbank after his term ended last year. Svensson opposed keeping interest rates high, arguing in a recent paper that the practice actually increases the ratio of household debt to GDP by restraining inflation and economic growth.
It is still too early to tell which camp is correct, but what happens in Sweden is likely to help shape the Fed’s debates over the topic in the coming years.
Bank of Israel
Newly sworn-in Fed Vice Chair Stanley Fischer won praise in 2009 for carefully shepherding Israel’s economy through the global financial crisis virtually unscathed while he led the central bank there. That was the year the Bank of Israel became the first major economy to actually raise interest rates, following a brief and mild recession.
But in more recent years, the bank was in the spotlight for a different reason: cutting interest rates. In one surprise move in 2013, Fischer slashed the rate in an unscheduled meeting amid concerns that the country’s currency had gotten too strong, undermining its critical export industry.
Many analysts believe the easing cycle is over -- the bank held its rate steady at its last meeting in May -- but Israel’s experience shows just how nimble officials need to be in responding to an evolving recovery.