It has become de rigueur for global markets to worry about the implications of the U.S. Federal Reserve’s moves on monetary policy, especially relating to quantitative easing (or QE3 for short). The decision that will come from the Federal Open Market Committee tomorrow afternoon has more than the usual significance. Chairman Ben Bernanke indicated to Congress in May, and repeated in a news conference in June, that the Fed was actively considering criteria for reducing purchases of Treasurys and mortgage-backed securities from their current level of $85 billion per month.
Markets are worried about the possible adverse impact on equities and bonds of a “tapering” of bond purchases. Stock markets have benefited immensely from the easy money policyaEUR"the S&P 500 index is at almost 1,800, compared with the low of 666 recorded during the financial crisis. And bond purchases by the Fed have lowered mortgage rates and borrowing costs, helping to boost home prices as well as corporate bottom lines. Will these results be undone if the Fed were to reduce its purchases?
To judge this, it is important to consider the magnitude of the Federal Reserve’s balance sheet expansion. From about $800 billion in September 2008, assets held by the Fed will likely hit the $4 trillion mark by year-end, a quintupling in about five years (see chart below). Since this is without precedentaEUR"in the United States and in the worldaEUR"unwinding may pose a significant threat to the economy and markets. To minimize any adverse impact, the Fed has repeatedly emphasized that tapering is not the same as tightening monetary policy. Until the unemployment rate declines far below the current 7 percent level, various Fed governors have indicated, interest rates will not be raised.
Federal Reserve total assets (weekly).
The high degree of uncertainty also stems from recent statistics. While some have been encouragingaEUR"for example, retail sales increased a healthy 0.7 percent, and unemployment fell from 7.3 percent to 7 percent in NovemberaEUR" other data urge caution. The labor force participation rate of 63 percent is the lowest since 1978. If that gauge were at 66.4 percent, as it was at the beginning of 2007, todayaEUR(TM)s unemployment rate would be more than 10 percent! Another disquieting factor is that when we include frustrated workers and those working part-time involuntarily (known as the U6 measure), the unemployment rate rises to an unacceptable 13.2 percent. Third, inflation is running well below the Fed’s target of 2 percent, leading some “dovish” members within the central bank to suggest that tapering would worsen the disinflation problem.
On top of all this, there is an unstated worry within and outside the Fed. Could it be that even the positive statistics are largely the result of the easy monetary policy that has prevailed since the financial crisis? Just as a patient who has been on painkillers for five years has to wonder how heaEUR(TM)ll feel when the drugs are cut off, the economy’s prospects are unclear should Dr. Bernanke or Dr. Yellen reduce the dosage of QE. That explains the concerns of bond and equity investors about what a post-taper economy would mean for financial markets.
Considering its decision tomorrow, the Fed has two options. It could punt, continuing bond purchases at their current pace, and leave it to Janet Yellen, the presumptive successor as Fed chairman, to implement a policy change after she assumes office February 1. Second, it could taper by a small amount. Say, reduce monthly bond purchases to $75 billion while providing assurancesaEUR""forward guidance"aEUR"that it will maintain its relatively easy monetary posture for some time to come. What will the actual decision be? It’s too close to call.
What ought the Fed do tomorrow? If the economy has not returned to a sustainable, healthy growth trend even after five years of QE, the medicine should be changed rather than the dosage increased (more on this in a future blog). In addition, the Fed’s repeated statements that its measures would be data-dependent have actually added to the overall confusion. After all, if two data points are positive and one is not, what are investors to make of the forward guidance? Even with such preparation, it is generally unclear to what policy change a specific positive data-point would lead.
My prescription, therefore, is that tomorrow the Fed begin the process of progressively reducing bond purchases with a clearly enunciated schedule that is not data-dependent. While such a policy switch may spook markets in the short run, it is the only way to move investors toward making decisions based on fundamentals rather than judgments based on steady infusions of the monetary drug.