U.S. credit and foreign-exchange markets have suffered through an excruciating several weeks, affected not only by the usual fluctuations in optimism and pessimism about the economy and inflation, but also by uncertainties about the attitudes of policymakers in Washington.
The administration, Congress, and the Fed all contributed to the confusion. But they have all, with varying degrees of success, also tried to correct the situation by clarifying their present views and intentions.
The Federal budgetary process created great uncertainty for a while when doubts were strongest about whether Congress and the administration would get their acts together.
The uncertainty abated when the House passed - though barely - the budget-reconciliation bill, which helped long-term bond yields recover from an earlier nose-drive.
The Senate has yet to pass its version, but it seems to be moving forward as the Democrats look ready to reach a compromise among themselves on tax and expenditure programs.
The compromises that have to be made are not particularly easy, though. Whatever revenues are given up by forgoing energy taxes will have to be made up either through other taxes or cutbacks in entitlement programs.
All in all, by the time the budget process is completed, I would nonetheless expect U.S. fiscal policy to be a little more restrictive than the administration's original proposal - after taking account of the defeat of the original near-term fiscal stimulus and assuming that many of the new longer-run investment and spending incentives proposed earlier will not be enacted.
The Dollar's Woes
The foreign exchange market has also suffered from official uncertainty. For a time the dollar weakened across the board, partly because the market believed a weaker dollar represented administration policy - perhaps not explicit policy, but at least implicit acceptance of such a market trend.
However, a generally weak dollar not only has potential negative effects on domestic bond and stock markets but also risks damaging the administration's stature at a time when it is seriously seeking to restore political credibility.
Thus, U.S. officials finally made it clear that they would like to see a stable dollar on exchange markets. In practice, that probably still means some decline in the dollar against the yen would be acceptable so long as the dollar was stable to strong against other key currencies, as it has been most recently.
It would be very advantageous to the Federal Reserve of its policy decisions could be made in an environment in which markets were not destabilized by budget and foreign-exchange uncertainties.
It is going to be hard enough to evaluate the significance of economic and price data, even without interference from excess market noise.
Leaks and public statements by policymakers make it clear that the Fed has been carefully considering the conditions under which it would tighten.
It is doing so rarely because anti-inflation credibility would be damaged if the inflation rate of the first four months of this year continues unabated, and particularly if it creeps up further.
Many analysts expect forthcoming data to show an abatement of upward price pressure. If so, that should be very welcome news at the Fed since it would help to resolve the evident dilemma about tightening.
Time to Reflect
The Fed does need more time to judge the underlying strength of the current expansion. Moreover, there is a great deal to be said for keeping monetary policy on an even keel until the dimensions and timing of the tax and expenditure provisions of the budget package become clear.
Nonetheless, if the economy is showing reasonable growth, it would be also prudent to avoid a sustained period when the overnight money market rate (the federal funds rate) is noticeably negative in real terms, as was the case in the first four months of this year.
At its mid-May policy meeting, the Fed appears to have resolved its dilemma by postponing a decision. It refrained from action - and wisely so at that point, in my view - but also indicated through leaks, which is not a very wise precedent, that it is willing to contemplate tightening.
The untraditional way in which the Fed's policy decision was communicated to the markets seems to be a sign of how difficult is the decision-making process at a time when both domestic and global economies are sluggish.
That difficulty also makes it quite important to avoid fiscal and exchange-market policies that could unsettle markets.