Two weeks since I blogged here. One of those spells. Interesting that the last blog post was on the day after Ben Bernanke (BB) testified to the Joint Economic Committee of the U.S. Congress. Financial markets have not been the same since then. This coming Friday is a big day for financial markets. We do not know if a strong report from the US on job creation would be welcomed or regretted. Odds favour market resentment of a strong number. All that they want is liquidity and not fundamentals. Chances of liquidity continuing to flow are higher when economy operates somewhat below its potential.
One of my good friends is convinced that Bernanke is serious about tapering or even totally withdrawing the additional stimulus (asset purchase) of 40 billion dollars per month put in place since last December. In fact, if I recall our conversation correctly, he said that the entire QE (asset purchases) might be stopped. I am not so confident of the U.S. economic recovery or the resilience of the recovery. Nor am I sure that BB and his team are that confident. As they have been at pains to stress, it could be just a one-month show or two-month tapering, followed by a pause and may be, even a restoration after that. Who knows?
On the contrary, they might be overconfident of U.S. resilience and that is why they are talking of ‘tapering’ so soon after launching QE3 in December. It is all very fuzzy.
Let us look at the case for tapering – a case that my friend articulated rather well. In the six months to March, job creation in the U.S. totalled 200K per month. But, that was also seen in 2011-12. Jobs growth tapered off after that. Then, he said that European peripherals are going to surprise markets with data improvement simply because they cannot fall any further. He added that unemployment rates going higher in peripheral Europe was not important since it had always been a lagging indicator. May be, he is right. But, I remain far from convinced. Not just the unemployment rate but many other indicators are still in bad shape in those countries.
Further, riots in Sweden and Turkey convince us that not all is well with the world in general. Not sure if it won’t spread to other smaller (but more prosperous) and peripheral European nations. However, I must add here that this Bloomberg story on Spain exports (first trade surplus in 1Q2013 since 1971!) bolsters my friend’s case considerably.
All told, I remain sceptical that Bernanke is really serious about tapering off. May be, all he wanted to do was to introduce a bit of caution with his verbal ‘tapering’. In fact, I am still expecting the ECB to join the printing party after September.
My friend believes that the FRB or at least BB is convinced that if they did not act now, bond yields would keep rising. He has a point. The 10-year U.S. bond yield rose 27 basis points even before BB’s testimony. May be, the bond market has begun to anticipate better economic activity or higher inflation or both or stagflation! So, the FRB may be getting into the mindset of the beginning of 1994 and mid-1999, when they began tightening.
David Rosenberg has a point when he points to the reduction in the unemployment rate from 8.1% to 7.5% even as the U.S. economy grew at only around 2% or below. He wonders if the potential growth rate is only around 1%. If the FRB shared his view, then they would be inclined to taper and taper more.
On the flip side, the biggest unknown for the Fed is the reaction in financial markets. The big question is whether financial markets would crater big time. On both those previous tightening episodes (1994, 1999-2000) they did. Not to mention the tightening in 2005-06. In fact, given the asymmetric nature of the FRB policy approach (ease more easily than tighten), the slide in prices of financial assets has been intensifying in each of these tightening episodes. Response to 1999-2000 tightening was worse than the response to 1994-95 and the response to 2005-06 tightening was worse than it was in 1999-2000. For that, the FRB has no one to blame but itself.
Like in 2002-04, the Fed had eased too much this time around too (QE3 on top of QE2) and remained easy for too long. It has spoiled the market by keeping rates too low for long and weakened its immunity against higher rates more and more. Now, the immunity must be at its lowest point. They, the markets, the U.S. economy and the rest of the world will have to pay the price for it.
[Parenthetically, it is very interesting that the Federal Advisory Council – a body of commercial bankers that advises the FRB – warned of the dangers of cutting interest rates to solve the student loan problem. Lower rates would encourage more borrowing and raise the potential burden on the taxpayer! Wonder if they had such clarity of thought on the Fed’s rate cuts and QE programmes. Is it easier to see the downside of reckless policies and prescriptions when one is not the beneficiary?]
This uncertainty over how would the market take it must be weighing on the Fed’s mind too. So, how they go about this very finely poised exercise will be interesting to watch. In 2006, after his speech at a conference when he spoke of ‘unwelcome’ developments on the inflation front, BB raised the Federal funds rate only once and left it there at 5.25% until 2007 when he had to start cutting it again. Even that rather timid tightening could not prevent a market collapse because much of the risk had been accumulated already when monetary conditions were too loose for too long. The situation post-2008 has followed the same trajectory. Hence, chances are that both their approach and the market reaction would be messy or messier, this time around too. That was my conclusion in my MINT column on Tuesday.
In mitigation, the Fed can point to the fact that they are only withdrawing the quantitative easing and not raising rates. That should shield the economy even if asset prices fall.
Two counter-arguments to that: the Fed has always stressed the linkage from from asset prices to wealth effect to consumption. So, shouldn’t they worry that the transmission from falling asset prices could take the economy down with it? Second and this is admittedly cynical, has the Federal Reserve really been bothered about the economy as much as it has been bothered by the health of the financial markets? Many would call this an unfair criticism but if they cared for the economy more, they would have allowed natural economic cycles to play out (Recall the FAC observation on the behavioural impact of lowering interest rates on student loans) providing a minimum of hand-holding to the really distressed segments of the public.
It is all very fuzzy because, in the end, we do not know if the Fed and its chairman know what they want and how to go about it.
[p.s: It makes sense to revisit these testimony/speeches of Bernanke made in March, May and June 2007. He made light of emerging troubles in the sub-prime mortgage market and stressed inflation risks. He remained poised to tighten monetary policy up to June-July 2007. In hindsight, it is clear that he had misread the economy’s resilience then. Is he about to make the same mistake, again? Not that if he did not taper off QE, the economy would become more resilient. That is an altogether a different story. QE was always going to be problematic and that is the only clear statement we can make.]