The Fed's Dilemma & the Week Ahead

Marc To Market * ZeroHedge

US foreign and domestic policies face cruel dilemmas. If the ban on chemical weapons is not enforced, the threshold will be more difficult to defend in the future. It risks undermining the credibility of the US, especially after a specific warning was issued. On the other hand, to strike without public support and a clear objective outside of punishment, a military strike also risks US credibility.

Monetary policy is far removed from the military issues, but has its own battle and credibility is arguably as important. In the spring, Fed officials indicated that with the economic recovery gaining traction, it would dial down the amount assets being purchased under the open-ended QE. Taking their clues from the Fed’s guidance, a full two-thirds expect the central bank to announce the tapering this week.

If the Fed fails to deliver, it will reinforce the criticism about the Fed’s communication effectiveness. Yet if the Fed tapers and demonstrates that its communication has indeed been effective as the majority of market participants correctly anticipated the tapering, it risks repeating its previous mistakes when it ended previous QE operations prematurely. Financial and economic conditions deteriorated and officials were forced to resume their asset purchases.

The Fed had traditionally eschewed a formal inflation target. The Bernanke Fed broke with tradition and adopted one. Yet, it appears poised to taper despite inflation being well below its target. In fact, as we have noted previously, the core PCE deflator is lower now than when the then-Fed governor Bernanke went to great lengths to explain the deflationary threat.

Headline inflation regresses to core inflation and core inflation tends to regress to labor costs. Labor costs in the US remain low and with the slack in the labor market, they are unlikely to pick up substantially any time soon.

At the same time, the Federal Reserve has habitually exaggerated the growth prospects of the US economy and has had to repeatedly reduce its forecasts for GDP. Its forecasts for this year’s GDP remain too high. They need to be cut in order to restore their credibility.

Can the Fed taper to retain its communication credibility and at the same time cut is GDP forecasts to retain economic credibility without undermining its overall credibility?

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http://www.zerohedge.com/contributed/2013-09-15/feds-dilemma-and-week-ahead