A word of appreciation for this post from Bibek Debroy, a renowned economist.
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 22nd 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.
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 30th 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.
References:
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
------------------------------------------------------------------------------------------------------------
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.
- - -
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:
