Fed up – down with QE?

Ben Bernanke’s discussion of the Fed’s policy intentions in the press conference following the Federal Reserve meeting on June 19 was a shock to markets, with all asset classes around the world falling sharply in response.  His remarks, together with the Fed’s revised economic forecasts for the US, indicate that the policy of QE will begin to be reduced when the unemployment rate falls below 7.5%, and would be stopped altogether when the unemployment rate falls below 7.0%.  Interest rates would only begin to be increased when the unemployment falls below 6.5%.  On the Fed’s economic forecasts, QE would begin to be tapered in September, and end by next summer, with interest rates beginning to be increased in 2015.

Financial markets were very surprised, and for five reasons as follows: (i) the Fed’s latest economic forecasts are optimistic regarding growth and inflation over the next eighteen months  – the Fed expect growth of about 3% over this period, faster than at any time since the crisis, and inflation rebounding to about 2%; (ii) the Fed’s forecasts for growth in 2013 and 2014 are lower now than they were last September when they announced the latest round of QE; (iii) Bernanke has always been very clear that the errors of US economic policy in the 1930s and Japan in the 1990s, following banking crises, lay in the authorities tightening policy too early and before the economies had fully recovered – it was thus expected that he would be slow to reverse QE; (iv) the rest of the global economy is not in a very fit state to cope with this move – Europe remains in recession, the Chinese recovery is not coming through as fast as had been expected, and Japan is just embarking on its own massive round of policy stimulus in an effort to revive its economy; and (v) Bernanke said it was significant that the total amount of QE would still be rising which  indicated easier monetary policy (i.e. lifting the foot off the accelerator) , whereas the markets focussed on the fact that it represented a change in the momentum of QE, and so see it as a tightening of monetary policy (i.e. putting the foot on the brake).

If Bernanke, and the Federal Reserve, are correct in their judgement that US economic growth is about to move higher, then future historians will judge Bernanke very well.  For over five years he has maintained near zero interest rates and extraordinary levels of money creation, which has allowed the US economy to perform better than the other developed economies.  Should the economy accelerate while coping with an ending of QE, as the Fed’s forecasts imply, he would be seen as having exercised tremendous courage during the crisis in adopting QE and tremendous judgement in reversing course and ending QE.

In recent years however the Federal Reserve’s forecasts for growth have been consistently over-optimistic, as the pick-up in consumer and business confidence and spending, which was the objective of QE, has been very slow to materialise.  Seen in this light, discussing the Fed’s policy intentions so openly may be seen as unwise.  If the expected growth acceleration does not occur, the markets have been given an unnecessary and unpleasant surprise, which would make it even more difficult to raise confidence and spending.

There are also other interpretations of the motivation behind Bernanke’s comments.

  1. The most likely is that the behaviour of financial markets in 2013 (up until Bernanke’s comments to Congress on May 22), which saw both bond and equity markets moving steadily higher whether the economic newsflow was positive or negative.  Markets appeared to be responding not to fundamental news but to the provision of liquidity from the QE policy – a feature typical of market bubbles.  By clearly discussing the potential to reduce or end QE, the liquidity support for markets is removed, and any bubble is pricked.
  2. Bernanke’s term as Chairman of the Federal Reserve ends next January 31, and the indications are strong that he will not be seeking to continue.  It may be that he does not want to leave office with a legacy of the most extreme, loose monetary policy that the US has ever employed, and is therefore keen to begin the process of returning policy to more normal settings.
  3. The most bearish (and least likely) interpretation is that he and the Fed no longer believe that the QE policy is capable of delivering growth, but that the risks of the policy, in terms of the scale of the money creation and potential inflation, are now too great.

Some immediate market implications are clear.  Bond investors were happy to continue buying bonds all the time they believed that the Federal Reserve would also be buying them through QE.  From 2003 to 2008, the Asian Central Banks pursued a policy of reinvesting their large trade surpluses into US bonds to prevent their currencies appreciating. From 2009 to now, the Federal Reserve has taken over the role of the lead buyer of US bonds.  The Fed have clearly signalled that they believe this period is near to an end – in the absence of a forced buyer, bond yields are likely to move towards more normal levels.  It will take a much slower economy and a return to QE for bond investors to become confident enough to become buyers again.  This move to higher yields is however likely to slow growth, and lead to lower valuations for all financial assets.

We expect growth not to meet the Fed’s forecasts, and so not trigger the pace of withdrawal of QE that Bernanke set out in the press conference.  Such an outcome is likely however to create confusion and uncertainty in financial markets over the next few months, as investors seek to guess the Fed’s reactions to every piece of news. Bonds are unlikely to perform for some time, and investors should look to reduce positions. Equity markets are not expensive but the outlook for growth is not exciting, except in Japan, and investors should wait for a clearer picture of the global economy to emerge over the summer, before making any significant changes to portfolios

Bernanke sets the printing presses to “GO” and walks away

The recent decision of the Federal Reserve to go ahead with a policy of QE3 by which they buy $40bn of mortgage and agency securities every month until further notice was dramatic and shocking in many regards:

  • Timing – Historically the Fed has sought to avoid making major policy moves in their last meeting before an election for fear of being seen to be acting politically. In 2008, there was a global crisis which required action – this is not the case in 2012.
  • Politics – Romney and many in the Republican Party have already made clear their opposition to Bernanke personally and to the policies of Quantitative Easing already adopted. Were Romney to be elected, he might choose to ignore the fact that Bernanke has been appointed until 2014 and seek to get him replaced. The Fed’s action can be interpreted as a major political snub at a critical juncture.
  • Economic justification – Both QE1 and QE2 were introduced at a time of clear weakness in the US  economy and significant financial market concerns about the possibility of deflation. So far this year, the US economy has been growing at about a 2% rate, unemployment has been declining gently and inflation expectations have been rising.
  • Size – At $40bn per month, the policy amounts to an annualised rate of QE of  half a trillion dollars. However, the reinvestment of principals and coupons and the continued working of Operation Twist (which followed QE2) mean that for the rest of this year the Federal Reserve will in fact be purchasing securities at an annualised rate of over a trillion dollars. These are astonishing amounts of money.
  • Transmission mechanism – In the press conference following the decision, Bernanke was asked about how he expected this policy to have real world effects. He repeated his  belief that by raising equity prices, companies would find it cheaper to invest. In addition, he said that because this time the Fed was buying mortgage securities, this would reduce mortgage costs in the economy, thus boosting house prices, so helping consumers to feel wealthier, which would encourage them to spend more. This trickle-down effect of previous QE policies from injecting money into financial markets moving into the real economy is widely believed not to have worked. It appears to benefit those in financial institutions whilst having little real economic impact.
  • Duration – By making QE3 open-ended and further insisting that the Federal Reserve would not begin to tighten policy until recovery was very firmly established, even at the risk of some higher inflation in the short term, Bernanke has made it very clear that continuous easing is now the default policy setting, probably for several years. Previous QE announcements were for set amounts of money over set periods of time – this is very different – money will continue to be printed until the economy recovers.

So the unlimited money printing of the Federal Reserve now sits alongside the unlimited buying of peripheral bonds by the ECB announced the week before  and the unlimited selling of its currency by the Swiss National Bank that has been in operation for a year. Central Banks – so long famed for their moderation and control in all things relating to money have set the printing presses to “GO” and walked away.

One conclusion that could be taken from this is that the Central Banks, who we hope are a little better informed about these things than the rest of us, are terrified, and that the state of the global economy and financial system is in fact far worse than anyone is prepared to admit.

The clearest market implications of this shocking move are to expect a weaker dollar (with so many more dollars now being printed) and a higher gold price. QE1 and QE2 were positive for equity prices, but the biggest beneficiaries were precious metals (gold and silver), oil and agricultural commodities. It is by no means clear that QE3 will do anything to boost real growth in the economy, and so the boost to equities may be more short-lived and less significant than previous rounds. Most interesting has been the recent moves in government bond markets where yields have risen as long-term expected inflation worries have begun to return.