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The Federal Reserve’s Very Delicate Balancing Act

This article was originally published on ftalphaville.ft.com on November 4, 2009.

The message from the FOMC is clear: let’s not rock the boat in the anticipation (or hope) that the U.S. economy can transition to more robust low-inflationary growth. To this end, the announcement at the end of the two-day FOMC meeting reiterates that policy interest rates will stay “exceptionally low” for “an extended period;” it welcomes the continued pickup in economic activity; and it enhances future policy optionality by listing a mix of variables that would be considered to assess whether inflationary pressures remain contained.

The FOMC is trying to strike a very, very delicate balance; a major question is whether markets and, more importantly, the real economy will be appropriately accommodating.

Markets welcomed the FOMC statement by initially doing more of what they have done in recent months: piling even more into the momentum trade for risk assets, and further increasing the dollar-funded carry trade that Nouriel Roubini wrote about in the FT on Monday. As a result, U.S. equity markets rose initially before succumbing to some profit taking; the dollar weakened substantially; gold surged; and the yield curve steepened.

It is totally rational for risk markets to rally in the very short term when the FOMC flashes a green light for the dollar-funded carry trade. The challenge is that, in the process, they accentuate what is already a wide gap between valuations and the outlook for economic fundamentals in 2010.

The risk for the U.S. is that, absent a sustainable and robust resumption of growth (driven by genuine private sector activity rather than stimulus and inventory cycles), the underlying economic and financial conditions are getting more unstable and not less – in other words, the Fed runs the risk of inadvertently pursuing short-term stability at the cost of longer-term instability.

Look for all this to re-ignite the difficult policy discussions on whether the Fed should lean against the wind in the context of market overshoots; to fuel concerns about the standing of the dollar as the global reserve currency; and to impart greater market volatility down the road.