On Wednesday, the Federal Open Market Committee left monetary policy unchanged. As they have done for months, Chairman Ben Bernanke and other Fed policymakers announced that the risks to the U.S. economy were balanced. Once again, they indicated that they would reconsider their stance as additional data dictates.
Unfortunately, while investors seemed to applaud the policymakers' lack of action, the truth is that the central bank's seemingly measured approach since Ben Bernanke's tenure began has had numerous unintended -- and unwelcome -- consequences. In my view, the Fed has:
• Encouraged bad behavior. By reassuring everyone that the economy remains in a holding pattern, policymakers have inspired investors to carry on as before: piling on leverage, taking excessive risks, and failing to prepare for the inevitable negative turn in credit, economic, and risk cycles.
• Fostered misperceptions about risk. Policymakers' continuing assertions that economic and inflation threats have more or less equal weight has engendered the illusion, in some quarters at least, that these two risks somehow cancel each other out, when it is the growing overall risk exposure that should matter most.
• Pointed investors in the wrong direction. The balance of recent economic data, including today's report on April retail sales, suggests that recession, rather than inflation, is the greater near term threat, but policymakers' have nonetheless managed to keep markets focused on the latter. As a consequence, investors have taken inappropriate actions that will come back to haunt them once the Fed acknowledges reality.
• Undermined policymaking effectiveness. In adopting what appears to be a reactive rather than proactive stance, the Fed has relinquished its leadership role, essentially leaving hedge funds, politicians, and foreign nations in charge of U.S. monetary policy.
• Laid the groundwork for future instability. With monetary policy being increasingly data-dependent, the risk is that policymakers will find themselves behind the curve at the worst possible moment. That boosts the odds that they will either under or overreact to a change in circumstances, or they will be totally blindsided by unforeseen events.
Despite what appears to be an unusually good start, Mr. Bernanke's next year on the job may not be so fortuitous.
The Wall Street Journal's MarketBeat Blog earlier noted some of my views on the subject in "Laissez-Faire Fed?"