US Fed Tapering Is Postponed-VRK100-19Sep2013

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A word of appreciation for this post from Bibek Debroy, a renowned economist.

@vrk100 Good piece.
— Bibek Debroy (@bibekdebroy) September 19, 2013

Summary:

The US Federal Reserve on 18 September 2013, at its Federal Open Market Committee (FOMC), decided to postpone its much talked-about tapering for the time being. This means the US Fed is maintaining its status quo of buying bonds worth $85 billion per month. It’s not clear when the Fed will start its tapering. With this flip-flop, the US Fed has made it difficult to predict when it will gradually reduce its bond buying program. Due to the moderate economic growth, low labor participation and recent rise in mortgage rates, the Fed has decided to postpone the tapering decision. With this decision, the US dollar is down, gold price is up, and stock markets too have cheered the Fed decision.

What is Fed Tapering?

Before we move further, let us see what is meant by Fed tapering. Tapering means to reduce gradually. In May this year, the Fed had hinted that it would decrease its monthly bond buying program (See more on QE3 at this end of this post) at a measured pace. At that time it was perceived that the tapering would start in September this year and would end by the middle of 2014. The markets had taken this news of US Fed tapering very negatively. Even though attempts were made to assuage the markets subsequently, the market perception did not change. The US Fed, the IMF and the ECB tried to calm the nerves of financial markets, by saying that they’d continue with their easy money policies as long as their economies remain weak.

This Fed’ hint of tapering its bond buying created a flutter in the financial markets. The yield of US 10-year Treasury increased from 1.6% in May 2013 to 3% in early September 2013. There was huge sell-off in securities, both shares and bonds, in the EMs resulting in huge outflow of money from EMs back to the developed markets. Against the US dollar, currencies in the EMs have depreciated very sharply—ranging from eight to 12 per cent.

Why the Fed postponed the tapering?

As clarified by the Fed chairman Ben Bernanke there are three main reasons for its decision to continue with its bond buying and postpone the tapering:

1. Labor force participation rate has declined—partly reflecting potential workers getting discouraged. Though the unemployment has fallen to 7.3 per cent, the fall is substantially due to people leaving the labor force.

2. There is a tussle in the US congress over passing of a bill to keep the government funded (if there is no agreement between the Republicans and the Democrats, it may lead to a government shutdown in the US). This tussle may dampen the economic growth.

3. Mortgage rates in the US have gone up recently (after the hint of tapering)

The status quo remains for now:

As far as the financial markets are concerned, the status quo remains for the time being. There is no change in the QE. The Fed will continue with its buying program at the current levels. In the words of FOMC:

“However, the Committee (FOMC) decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.”

This implies that the US economy is still facing challenges and the monetary stimulus is still necessary for achieving maximum employment and price stability. To stimulate the economy, the Fed will continue to print money.

  

What is the state of the US economy?

The US economy is improving, but at a moderate pace. The unemployment rate remains high even though there are positives in the labor market. Some improvements in the economy are: increase in household spending, growth in fixed investment and strengthening housing sector. Inflation is as per expectations. On the negative side, mortgage rates have gone up recently and the economic growth is constrained by fiscal policy.

In the last one year, unemployment rate has fallen from 8.1 percent to the current 7.3 percent and about 2.3 million private-sector jobs have been created. One of the reasons for dip in the unemployment rate is the decline in labor force participation rate owing to people exiting the workforce.

When will the Fed start its tapering?

Between May 22^nd this year when the Fed hinted at tapering and now, the financial markets—bond, stock, currency and commodity—have undergone immense volatility. EMs were subject to large outflow of funds. The Fed decision not to taper has taken the financial markets by surprise. In the last 12 to 14 hours, the global stock markets have gone up thinking that the Fed stimulus will increase fund flows into financial markets and EMs.

The tapering decision is now postponed. What lies ahead? When will the Fed start reversing its easy money policy? What is the timeline for the Fed to start raising the federal funds rate? The answers remain elusive. The Fed’s about-turn is bound to confuse the markets, making it difficult to forecast the future Fed decisions. The Fed will keep its focus on US economic growth and unemployment rate.

The Fed’s projections indicate the US economy may grow between 2.0 to 2.3 percent in 2013, rising to 2.9 to 3.1 percent in 2014 and 2.5 to 3.3 percent in 2016. The unemployment rate may decline to 6.4 to 6.8 percent in 2014 and to 5.4 to 5.9 percent by 2016. Inflation may remain between 1.1 and 1.2 percent in 2013; 1.3 to 1.8 percent in 2014; and 1.7 to 2.0 percent in 2016.

Overall, the Fed is expecting a moderate recovery in the US economy and its future monetary policy will be based on fostering maximum employment and price stability. My overall feeling is that the US would not be able to start tapering for another 12 to 18 months.

When will the Fed start increasing the fed rate?

Another persistent and relevant question that bothers the markets is when the Fed will start increasing the fed rate. The fed rate has been kept at a record low of 0 to 0.25 percent since December 2008.  

Related: The Fed rate has been cut to record low

What is the difference between US Fed rate and US Discount rate

The Fed has linked its bond buying program to the outlook for the labor market. So, any decision on a tight money policy, that is raising the federal funds rate, will depend on the labor market conditions. The Fed is committed to continuing the fed rate at record lows as long as the unemployment rate remains above 6.5 percent, and so long as inflationary expectations are well under Fed’s comfortable levels.

The Fed is categorical that a decline in the unemployment rate to 6.5 percent would not lead automatically to an increase in the fed rate. Once the unemployment rate goes below 6.5 percent, it will take a decision on the revision of fed rate keeping in mind the overall economic outlook and labor market conditions, especially job gains. In the words of the US Fed:

“…the first increases in short-term rates might not occur until the unemployment rate is considerably below 6.5 percent.”

Market Reaction:

The US Fed's decision has been welcomed by the world’s financial markets. The market perception is that the money taps will continue to be kept open by the central banks. The US stock indices have gone up by around one percent clocking record highs. The Asian stock markets have gone up by two to four percent.

The US dollar is down, while gold and oil prices are up. 

Conclusion:

The Fed has flagged certain fiscal policy problems for the US economy. It is concerned that these problems could be detrimental to the economic growth. There is an ongoing controversy in the US congress over government funding deadline of 30^th September. These may entail certain risks for the markets in the coming weeks or months.

The fact that the Fed will continue to print money seems to have cheered the markets. However, there is one dissenting voice in the FOMC. Ester George, one of the FOMC members has cautioned that the massive bond buying program may result it future economic and financial imbalances and higher inflation.

The real problem is that the markets may react violently again when the Fed decides to start tapering. In fact, the admission that the US economy’s growth has moderated should be a negative in the medium term for the markets. But, the markets are currently happy with the Fed decision.

I think market will have to realize the larger picture at some point in future. The reality is that one day these central banks have to stop their massive liquidity injection programs, resulting in large money outflows from emerging to developed markets. 

We need to keep our focus on the ensuing economic indicators.

Related: Emerging markets are down but not out 

References:

FOMC press release dated 18Sep2013

Bernanke’s press conference

Photo courtesy: US Federal Reserve.

Abbreviations:

BoJ – Bank of Japan

DMs – Developed Markets

ECB – European Central Bank

EMs – Emerging Markets

IMF – International Monetary Fund

Taper Tantrum

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Additional Reading

I. What is QE3?

After the 2007/2008 global financial crisis, the Fed has been trying to stimulate the US economy with its easy money policy. The Fed has been following an unconventional monetary policy of buying bonds called quantitative easing (QE) as it cannot further lower the current federal funds (fed rate) target of 0 to 0.25 per cent. In the last six years or so, the Fed has increased its monetary base by almost four times as part of the QE, whereby it buys bonds from commercial banks and other financial institutions.

This is aimed at decreasing interest rates and boosting the US economic and job growth. As part of its quantitative easing (QE) program started in September 2012, the Fed has been buying bonds worth $85 billion per month—consisting of US Treasury securities worth $45 billion and mortgage-backed securities (MBS) worth $40 billion. This is the third version of the program, called QE3.

In the first round of quantitative easing (QE1) between November 2008 and March 2010, the Fed bought MBS worth $1,250 billion and agency MBS worth $175 billion, in addition to purchase of US Treasuries. In the second round (QE2) between November 2010 and June 2011, the Fed bought US Treasuries worth $600 billion. Officially, the QE program is known as large scale asset purchases or LSAPs. In layman’s lingo, the QE has increased money supply by leaps and bounds in the banking system, resulting in massive printing of US dollars. This tremendous liquidity has flown out of the US and reached several financial centers around the globe, inflating prices of commodities, EM securities and other asset classes.

II. What monetary policy tools are used by the US Federal Reserve?

In normal times the Fed eases monetary policy by lowering its target for the short-term policy interest rate, known as the federal funds rate, or fed rate. For more than 50 years, the Fed has used the fed rate as a conventional monetary policy instrument. In December 2008, the Fed decreased the fed rate to a record low of 0 to 0.25 percent. After that, the Fed was forced to use other unconventional tools at its disposal, due to the fact that current federal funds rate of 0 to 0.25 per cent could not be lowered further. So, how could the Fed signal interest rates in the economy?

Since the latter part of 2008, the Fed has been using the following two tools:

1. Large scale asset purchases, commonly known as quantitative easing, whereby the Fed has been buying US Treasuries, MBS and others; and

2. Forward guidance about short-term interest rates; that is, communicating its plans for setting the fed rate target over the medium term.

III. What is the mandate of the US Fed?

As per the Federal Reserve Act, the statutory objectives for monetary policy are: maximum employment, stable prices and moderate long-term interest rates. The Fed tries to target inflation rate at two percent. Further, the objectives of the monetary policy should be explained to the public as clearly as possible fostering better communications; enhancing transparency and accountability; and reducing economic and financial uncertainty.

IV. Why is US inflation not rising despite increased money supply?

Even though the Fed has increased its balance sheet by almost four times in the last six years, there has been no alarming increase in the US inflation. This is due to the fact the US commercial banks’ lending growth is sluggish.

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Disclaimer: The author is an investment analyst, equity investor and freelance writer. This write-up is for information purposes only and should not be taken as investment advice. Investors are advised to consult their financial advisor before taking any investment decisions. He blogs at:

http://ramakrishnavadlamudi.blogspot.in/

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The US Fed Raises Discount Rate-Why Did They Do It?-VRK100-28022010

The US Fed Raises Discount Rate-

Why Did They Do It?

Rama Krishna Vadlamudi                    February 20th, 2010


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On February 18^th, the US Fed has given a mild surprise to the financial markets by raising the discount rate by 25 basis points from 0.50 per cent to 0.75 per cent. This is the first major move by the US Fed as part of its exit strategy. Reacting strongly to the Fed move, the US dollar has rallied against the Euro and Pound Sterling. The dollar hit a nine-month high against euro with the euro quoting at 1.35 on Friday. The Euro’s recent high was 1.50 against the US dollar in December 2009. The dollar rallied against the Japanese Yen and pound sterling also – the Yen weakened up to 92 while the pound depreciated to a level of 1.55 against the dollar. The stock markets reacted negatively to the discount rate hike and major indices across, the US, Europe and Asia-Pacific witnessed cuts in the range of one to two per cent on Friday.

While raising the discount rate, the Fed has indicated that this is a not a signal for modifications in the outlook for the economy or the monetary policy. Several policymakers does not want to dub this as a withdrawal of stimulus, rather they would love to call it as a “normalization process,” a new word they designed for their latest actions as these financial systems seem to have come out of the crisis situation.

What inferences can be drawn from the hike in Discount Rate?

1. It seems to be the end of cheap money. Till now, investors used to resort to dollar carry trade by borrowing from the US market at zero or near zero interest rates and invest in commodities or stock markets of emerging economies. This is the serious beginning of an exit strategy from the Fed.
2. There is a marked upturn, however fragile it may be, in the US economy and as such the US Federal Reserve is more confident about the sustainability of US recovery in the next three to four quarters
3. However, Ben Bernanke, the US Fed Chairman, has stated that the interest rates will remain “exceptionally low” for “an extended period of time.” It means that the Fed may not raise the all-important benchmark Federal Funds Rate (Fed Rate) for the next three to four quarters as the US unemployment is hovering close to 10 per cent even now.
4. Even though the US fed funds rate is kept near zero, the Fed has started to unwind other unconventional liquidity measures on an ongoing basis
5. This confidence about the US recovery is good for the  US dollar and the optimism is already showing in the strength of US dollar against euro and pound sterling with the US dollar index hovering around 80 as of now
6. The strong dollar could also be a dampener for the prices of commodities in the short-term. However, the inverse correlation between the commodities and the US dollar may come to an end sooner than later.

What is US Discount Rate?

It is the rate charged by the US Fed for the banks who require emergency money for their short-term requirements. It is similar to the Repo rate in India – it is the rate at which commercial banks in India borrow funds from the Reserve Bank of India for their short-term, usually one or two days, needs.

However, the discount rate does not directly affect the borrowing rates for companies, customers or mortgage rates in the US. As such, the hike in discount rate is as merely symbolic with no impact on interest rates in the economy.

What is the difference between the Fed Funds rate and discount rate?

The Federal funds rate (or simply known as Fed rate) is currently pegged at between zero and 0.25 per cent. The Fed sets the Fed funds rate also. It is the benchmark rate at which banks lend to each other. The federal funds rate is an overnight lending rate among banks/financial institutions in the US. The rate is also used as a benchmark rate by banks to fix interest rates for other loans, like, mortgage loans, business loans, consumer loans and loans to credit card holders. The US Fed uses the federal funds rate as a tool to balance its objectives of economic growth and price stability. Whenever inflationary expectations are high in the economy, the US Fed tries to control inflation by hiking the fed funds rate. On the other hand, if there is a slowdown in the economy, it will try to inflate the economy by lowering the fed funds rate.

The Fed funds rate is similar to the call money rate through which Indian banks lend or borrow among themselves to meet their short-term funds requirements or lend their short-term surplus funds to other needy banks. However, the RBI has no direct control over call money rates in India. They are purely driven by supply of and demand for money among the commercial banks and primary dealers.