The Next Step in the Fed’s Beautiful Normalization

(Bloomberg View) -- The Federal Reserve on Wednesday is expected to provide details on the implementation of the next step in what so far has been an orderly gradual multiyear normalization of unconventional policies, a process that has confounded many who saw the May 2013 "taper tantrum" as a precursor to the unsettling volatility to come. Here is how to think about the what and the why, and their potential implications for what’s ahead.

At the end of its two-day Open Market Committee meeting, the Fed is likely to provide operational specifics on the measured and conditional reduction of its $4.5 trillion balance sheet -- namely, the timetable for the roll-off of its holdings of Treasury and mortgage securities. Officials aren't likely to signal major revisions to their interest rate forecast (the blue dots). Specifically, they will refrain from meaningfully validating what currently is too low a market probability of a hike in the remainder of the year. That policy guidance is more likely to come later.

Investors and traders are sanguine about the initiation of the balance-sheet reduction, having already navigated in an orderly fashion the termination of the Fed's program of large-scale security purchases and three rate hikes. As an illustration, the VIX -- a widely followed indicator of market volatility commonly called the "fear index" -- was trading down at 10.15 on the eve of this week's FOMC meeting, after fluctuating in a range of 8.84 to 23.01 in the last 12 months.

Several factors are contributing to this notable market calm. The global economy is in the midst of a synchronized growth pickup, though it is far from impressive and below what it is capable of (and needs). Judging from remarks of Fed officials, the central bank remains keen to avoid market disruptions. Meanwhile, the European Central Bank and the Bank of Japan continue with their large purchases of market securities.

All this serves to fuel the adaptive expectation process that has created high market confidence that central bankers are able and willing to deliver a "beautiful normalization" -- to adapt a phrase coined in another deleveraging context by Ray Dalio, the founder of the hedge fund Bridgewater -- starting with the Fed, the world's most powerful and influential monetary institution. That is, they will manage a slow and orderly exit from unconventional measures that neither derails economic growth nor causes financial instability.

This unprecedented and delicate policy maneuver is far from an automatic.

It remains to be seen whether, unlike the last pickup in global growth in 2010, the underlying engines this time will develop durable and strong growth momentum for the medium term -- a question that assumes greater urgency for politicians who continue to lag in addressing structural and cyclical headwinds to productive economic activities. It also remains to be seen whether the Fed will maintain such a steadfast policy commitment in the face of a significant upcoming turnover in membership of the Board of Governors.

These risk factors are compounded by what I view as the biggest uncertainty of all: how the global economy and markets respond when more than one systemically important central bank seeks to normalize monetary policies.

For now, markets will continue to treat the Fed's normalization as the equivalent of watching paint dry: a slow, uneventful and relatively predictable process. Whether such expectations are validated over the longer term, however, is far from clear.

The challenge goes beyond the Fed continuing to pull off a "beautiful normalization." It also requires a sustained pickup in economic growth that allows both the ECB and the BOJ to follow suit. And for that, the advanced economies need to take a significant step up in a pro-growth policy formulation that reduces what has been a protracted and excessive reliance on central banks.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He was chairman of the president's Global Development Council, CEO and president of Harvard Management Company, managing director at Salomon Smith Barney and deputy director of the IMF. His books include "The Only Game in Town" and "When Markets Collide."

To contact the author of this story: Mohamed A. El-Erian at melerian@bloomberg.net.

To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.

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