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World central bank? Uneasy role for ultra-easy Fed

JACKSON HOLE, Wyoming - Federal Reserve officials gathered at this quiet mountain resort may hear some noise from their international counterparts about side-effects of the central bank’s ultra-loose monetary policy.

In Japan, there is growing fear a rallying yen, whose fate has been closely linked to the prospect of fresh stimulus by the Fed and diminished returns on U.S. securities, will put a damper on the country’s already soft recovery.

Officials in emerging markets also have qualms about the Fed’s policy, if for different reasons.

Currencies in Latin America have surged, raising worries about the cost of local exports and the chance that speculative investments flooding countries like Brazil, Chile and Peru, create the potential for a sharp reversal.

Chile’s finance minister complained that the peso’s appreciation of nearly 7 percent against the dollar since early July would be hard to stop given the U.S. backdrop.

“If... the U.S. economy is growing weakly and there are no expectations of a rise in (U.S.) rates, it is very difficult to battle against that,” Felipe Larrain said earlier this month, adding that rising prices for Chile’s main export, copper, also contributed to the country’s currency surge.

Of course, the Fed’s mandate is to support maximum sustainable employment and stable prices in the United States, not to fret over the effects of its policies on other nations.

“The Fed is going to concentrate on helping the domestic economy,” said Dana Saporta, economist at Credit Suisse. “The knock-on effects on other countries are a secondary concern.”

That may be so, but in highly interconnected financial markets, it becomes difficult to isolate the two.

“There is a very strong correlation between interest rate differentials and dollar/yen,” said Steven Englander, a currency strategist at Citigroup.

Not that this is the only factor. Risk-aversion in markets has also benefited the yen. Similarly, it would not be in the interests of Japan nor Latin America to see the U.S. recovery stall.

“The main concern everyone has is a double-dip recession in developed economies,” said Jeff Grills, co-head of emerging market debt portfolios at Gramercy in Greenwich, Connecticut.

Sympathy from lone dissenter

Nations indirectly affected by Fed policy may get some sympathy from host of the Jackson Hole symposium, Kansas City Fed President Thomas Hoenig, who has dissented at every one of the Fed’s policy meetings this year.

He has argued that by keeping interest rates too low for too long, policymakers run the risk of stoking financial bubbles in unexpected places.

But the rest of the powerful Federal Open Market Committee will be harder to win over.

Bernanke has made clear in the past that he sees his job as doing what is optimal for the U.S. economy.

And with the Fed missing the target on both sides of its mandate — unemployment stands at an elevated 9.5 percent and core inflation at an uncomfortably low 0.9 percent — the prospect of further easing looks increasingly plausible, even if there are doubts about its effectiveness.

U.S. data out this week showed things are getting worse. Housing figures were terrible across the board, raising concerns about a new home price slump in the absence of a recently expired home-buyer tax credit.

Durable goods orders were no better, and prompted JP Morgan to predict third-quarter growth domestic product might come in below a 1 percent annualized rate.

Comfortably unorthodox

If the trend continues, the Fed could attempt to buy up more Treasuries to push down long-term rates.

Despite some signs of internal dissent, Bernanke remains the definitive leading voice in the committee, and he is unlikely to hesitate in taking further action if the economy looks set to contract.

Earlier this month, the Fed announced it would begin using the proceeds from maturing mortgage bonds in its portfolio to buy Treasury notes in such a way as to keep outstanding credit to the banking system steady at just over $2 trillion.

Is it possible that the Japanese authorities, which have a long record of mutual respect and cooperation with the Fed, might help dissuade the central bank from further action? Probably not. If push comes to shove, the Fed will step in and provide more stimulus, say analysts and investors.

During a chat with reporters in Rogers, Arkansas last week, St. Louis Fed President James Bullard dismissed the notion that a zero benchmark rate meant the central bank was anywhere near out of bullets on policy.

Bernanke’s famous 2002 speech, “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” suggests he feels the same way.

Ironically, it is Japan’s experience of deflation that most vividly reminds Fed officials of the difficulties of using monetary policy to battle a persistent and vicious cycle of falling prices. It’s a rut the Fed would rather not slip into, but one that appears uncomfortably possible.