by Michael Collins, Investment Commentator at Fidelity
Stan Druckenmiller, a star US hedge-fund manager, slams the Federal Reserve for “running the most inappropriate monetary policy in history”.1 But what seems to scare investors more is the prospect that the Fed’s quantitative easing will end soon.
Financial markets wobbled after Fed Chairman Ben Bernanke on May 22 said the Fed could wind down the unorthodox monetary tool, whereby a central bank, having already slashed its cash rate to close to zero, conjures liabilities on its balance sheet to buy financial assets. The aim of the policy is to lower long-term interest rates to encourage consumers to spend and businesses to invest.
The policy, first tried in Japan in 2001, has helped the world avoid the deflation and depression that dogged the 1930s. While the ability of quantitative easing to spur economic growth is more debatable, for it has failed to stir a lasting recovery, it’s clear the practice carries side effects, including beneficial ones for financial assets. Druckenmiller and others say the Fed’s asset-buying misallocates resources (hard to prove) and will unbuckle inflation expectations (no sign of that happening). Other alleged spin-offs are so-called currency wars (inadvertent) and inequality because the practice favours asset owners (as the Bank of England admits).2 The asset-buying has certainly propelled bonds to record low yields, even Netherland bonds that were first issued in 1517,3 and boosted stocks to fresh peaks.
A definitive assessment of quantitative easing must wait until the practice ends. Many worry it will finish badly. They fret that the great monetary experiment of our time is yet to be halted seamlessly in any country as its economy reignites. Japan has conducted bursts of quantitative easing over the past 12 years (thus temporarily ending it), but without revitalising its economy. But there are no reasons why quantitative easing can’t end smoothly enough for the US as its economy rebounds. It may, however, prove more troublesome for other parts of the world.
The declared Fed policy is that it will reduce its asset purchases worth US$85 billion (A$90 billion) a month in steps any time now, if economic, especially jobless, readings justify a less-promiscuous policy. The Fed expects that by mid-2014 it will have stopped the asset-buying that has swelled its balance sheet to US$3.7 trillion from US$894 billion at the start of 2008. By then, the Fed expects the jobless rate to be under 7%, from a four-year low of 7.3% in August.
The Fed can alter, even reverse, its actions at any time if the economy changes beat. Bernanke, aware that policymakers wrecked recoveries in the 1930s by braking too soon, says he won’t allow “a premature tightening”.4 But such comments to Congress have failed to soothe investors and speculators. Since the end of May, these “feral hogs”, as Richard Fisher, the President of the Dallas Fed described them to the Financial Times,5 have walloped bonds (thus boosted interest rates) and driven up the US dollar while undermining stocks, especially emerging ones, and commodities.
The financial reaction surprised Bernanke. Perhaps he failed to realise how addicted market players have become to their central-bank fix – so much so that promising reports on the US economy now trigger turbulence for they reinforce that the Fed’s asset purchases will slow soon. Another problem, though, is that some people see so-called tapering as a squeeze on credit, the scourge of the Great Depression. But tapering is not a tightening of monetary policy. If the Fed spends one dollar buying assets, it is easing monetary policy. Once the Fed stops buying assets, then monetary policy is in neutral.
The reason why the ending of quantitative easing is unlikely to be threatening to the US is that the central bank doesn’t need to sell the assets purchased under the program (outside of its normal trading of securities on the money market to control the cash rate). The central bank can hold the bonds to maturity, for, under a system of fiat money (when notes and coins are backed by nothing), the size of a central bank’s balance sheet is peripheral. The dimensions of the monetary base (notes and coins in circulation and bank reserves held at the central bank) have no influence on the Fed’s ability to control the cash rate and thus inflation. When central banks in the 1990s moved to a system of announcing cash-rate targets, they snapped the link between the money supply and the cash rate.
The political reality, though, (and Fed officials are attuned to that) is that the puffing up of the Fed’s balance sheet has sparked warnings of inflation, asset bubbles and economic imbalances. Bernanke admitted to such risks on May 22 when he told Congress the Fed’s loose policies could “undermine financial stability”.6 Fed officials want to shrink the balance sheet for they anticipate blame for any financial mishaps while it stays bloated. The Fed can be expected to sell assets to trim its balance sheet, and if it does, it’s tightening monetary policy. The Fed will only do this if the economy is humming enough to stoke inflation beyond its 2% limit. By selling assets, the Fed wouldn’t need to raise the cash rate as much as otherwise to keep inflation benign. This will help the recovery for it will receive fewer Fed-raises-rates jolts.
A bond surprise
Amid the tapering talk, US 10-year Treasury yields have risen about 130 basis points from 1.67% on May 1. (They peaked 2.99% on September 5.) The ending of quantitative easing may have a less-dramatic effect on US yields over the rest of the year, though. Investors have priced in the Fed’s intentions and the economic data is modest. (The US economy expanded at an annual rate of 2.5% in the second quarter). Investors are reassured that the Fed will be flexible about curtailing its asset-buying if circumstances demand and they think the central bank is determined to keep the cash rate low. Analysts only expect one 25-basis-point rise in the US cash rate in the next 12 to 18 months.
The biggest risk with ending quantitative easing is that even small increases in borrowing rates could torpedo the US recovery. The US economy’s rebound is wobbly as it is battling reduced fiscal stimulus, stricter bank-lending practices, a feeble eurozone recovery and a slowdown in China. Another risk to the Fed in shrinking its balance sheet is that it will realise losses on bond sold, if interest rates are climbing. That will force a de facto tightening of US fiscal policy. These concerns can be offset by the fact that any dip in economic growth could lead to a renewed loosening of monetary policy.
Investors can expect endless speculation about how and when the Fed will act. The jobless rate will be the best guide but the official rate fails to capture the intricacies of the labour market. The better official employment numbers shroud that many of the jobs created are low-paid and part-time and that many people have dropped out of the workforce. The gains in jobs may not empower the economy that much. The Fed could remain a bond buyer until the official jobless rate is well under 7%.
The reactions on financial markets to every economic release or Fed utterance can be considered a cost of slowing or reversing quantitative easing. The Fed should worry about bond yields for higher interest rates threaten the recovery. The Fed’s job is to control US inflation and promote US economic growth. It can ignore gyrations on currency, commodity, property and stock markets that have no obvious consequences for the US economy.
It’s hard to see how the ending of quantitative easing can ignite inflation when it will only boost interest rates, which would subdue inflationary pressures. The threat of deflation dispels notions of a bond bubble so it’s not likely that Bernanke will trigger a 1994-style bond crash. The big surprise of the ceasing of quantitative easing could well be how little disruption this causes in the US.
The ending of quantitative easing, however, may be more complicated elsewhere. The widespread use of the US dollar in trade and in pricing assets and the fact that many currencies are linked to the greenback ensure that US monetary-policy shifts are transmitted around the world. The problem is that while the US economy is recovering many other countries are struggling. Those with currencies tied to the US dollar are losing their export competitiveness as higher US interest rates are boosting the greenback.
The region most at risk is Europe, even with a free-floating euro. The ending of the Fed’s asset-buying may trigger a rise in global bond yields that, however gentle, hampers Europe’s economy, while exposing the limits of the European Central Bank’s bond-buying promise to save the euro. Investors may discover that the ECB can’t keep bond yields of troubled sovereigns at low-enough levels to keep governments solvent, just as a slowdown shoves more pressure on public finances.
Emerging markets are vulnerable in a different way. When quantitative easing started in 2009, US money fled to emerging markets to seek higher returns. The US-sourced capital may gush home if US yields rise. Investors fret that more emerging countries might need to raise interest rates, and thus curb growth, to attract capital to offset current-account deficits and protect their currencies from a slump that triggers inflation via higher import costs. Central banks in Brazil, India, Indonesia and Turkey lifted key rates and took other steps in recent months to prop up their currencies and balance their balances of payments. (India’s moves included capital controls).
The Fed’s actions, however, might be less of a concern than the other causes of economic slowdowns already underway in much of the emerging world. Brazil confronts falling commodity prices, sluggish growth and inflation. China is battling excessive lending. Inflation-prone India is heading to its biggest balance-of-payments crisis since 1991 because politics have stymied reform. Central European countries such as the Czech Republic, Hungary and Poland are largely untouched because their economies are better balanced. Heightened US economic activity sucking in imports may offset some of the short-term damage of the tapering, which will probably prove a hiccup for emerging countries rather than trigger a crisis. Most of the capital directed at the emerging world in recent years was for long-term investment and many countries have low foreign-debt-to-income levels and enough reserves to cope with the whims of speculators. The emerging world’s favourable demographics, abundant raw materials, rising middle class, pro-business policies, large savings pool and low labour costs will nurture its industrialisation for years to come.
Australia is better placed to cope than most countries from any Fed-induced buffetting. Australian bond yields will tick up to some extent with US yields but not fully as China’s slowdown is crimping growth and containing inflation. While rising local yields will slow the economy and steeper global interest rates will add to foreign-debt repayments, the Australian dollar will probably slide to more competitive levels and help our economy overcome the sag in the resources boom.
Over in Washington, the US-taxpayer-funded Fed should just focus on managing the US economy. It should ignore the global repercussions of its policies unless they will hurt the US. Authorities elsewhere should just better brace their economies for a less-lax US monetary policy.
Financial information comes from Bloomberg unless stated otherwise.