Despite the US Federal Reserve’s decision in September not to begin to reduce its support of the US market and the economy, the US – and, indeed, the world economy – is in a sufficiently robust condition for the unconventional policy mix of quantitative easing (QE) and zero interest rates to be brought to an end.
Occasionally, financial markets become obsessed with a particular issue. An inordinate amount of analysis and commentary is being devoted to when and how the US Federal Reserve will end its present programme of quantitative easing.
QE, which can be described as printing money, sees the Fed buying $85 billion (R863bn) of mortgage and government bonds monthly.
This is the third time since the 2008 financial crisis that the Fed is massively increasing the size of its balance sheet. In 2008 it injected $1.3 trillion into the financial markets when liquidity disappeared following the collapse of Lehman Brothers. Then between October 2010 and June 2011, it injected a further $570bn in a programme now known as QE2. In December last year, it launched QE3. In contrast to QE2, this programme is open-ended.
When, and only when, the US economy is judged to be sufficiently buoyant will the Fed curtail and then cease buying bonds. It wishes to see unemployment below 6.5 percent. This exit process has been called “tapering” because the Fed plans to gradually reduce its monthly purchases as circumstances allow.
QE2 and QE3 have had a similar outcome. The money created has not stimulated any increase in bank lending. Since growth in bank credit is the normal transmission mechanism by which monetary policy affects the real economy, it can be argued that QE has not had a significant impact on economic activity. The money has largely ended up as cash deposited by banks, mainly foreign, with the Fed.
Proponents of QE argue that in a world of zero interest rates, the transmission mechanism acts by boosting asset prices and thus the confidence of homeowners and investors.
During QE2, the Fed expanded its balance sheet by 24 percent and share prices, as measured by the Standard & Poor’s 500 index, rose by 23 percent. So far during QE3, a 27 percent increase in the central bank balance sheet has been accompanied by an 18 percent rise in share prices.
Property prices are recovering. The rise in asset prices has restored household balance sheets to a healthier situation compared with what existed before the crisis, thus boosting confidence, which is needed for sustainable economic growth.
In addition to QE, the Fed has kept short-term interest rates at close to zero since 2009 and has indicated that they will remain there into 2015.
This constitutes a massive financial repression of savers. In a desperate search for returns, investors have pushed government bond yields to levels not seen since the late 1930s. In November 2012, the yield on the US 10-year government bond fell to 1.58 percent and the 30-year bond to 2.77 percent.
Proponents of these policies argue they are necessary and are having a positive impact. Critics say any benefits are temporary and the exercise distorts prices, which will have to adjust to reflect underlying realities.
Over the past six months markets have focused on the inevitable ending of this programme. The US economy survived going over the “fiscal cliff” between January and April this year when previously legislated tax increases and government spending cuts were implemented.
The fiscal cliff was a non-event, with predictions of disaster proving unwarranted. There is evidence the US is in a strong enough condition to end QE; the next step will be to revert to more normal interest rates.
Market participants are concerned about when and how QE will end. The Fed is holding down the yield on mortgage bonds. It is also buying about 70 percent of the US government’s new debt issuance. It is crowding out other investors, forcing money, which would naturally go into bonds, to find a home elsewhere.
This encourages investment in equities, especially shares giving a good dividend yield, and the purchase of emerging market debt. It is difficult to predict the impact of the ending of QE3. When QE2 ended in 2011 the US share market declined about 15 percent but recovered within six months.
Given the fact that QE has evolved into a massive manipulation of asset prices, the communication of how the Fed will manage its exit strategy becomes important. It does not want to trigger a financial crash.
The prevailing fashion among central banks is to place emphasis on effective communication of their policies. The theory is that by managing expectations, financial assets will be priced to discount efficiently the policy intentions of the central bank.
Whereas a former generation of central bankers took an almost malicious pleasure in surprising the market, the modern paradigm is to use effective communication to ensure there are no surprises. While the new approach is an improvement, it has a disadvantage.
Central bankers do not have better insight into the economy than private investors. On occasion, communicating sends the message that those who conduct monetary policy don’t know what they are doing.
The message degenerates to saying that future policy will depend on developments in the economy. While this should be an obvious truism, markets unjustifiably expect more from central banks, especially of one that has embarked on such an unconventional policy as quantitative easing.
US policymakers were taken aback by the market’s reaction to sensible and measured statements they made in May and June on the exit from QE3. The 10-year government bond has sold off from yields of 1.6 percent to almost 3 percent.
The reality is that, when assets are mispriced, any correction can be sudden and violent. The concern is that the Fed has created distortions in financial markets which may rapidly adjust to more realistic levels.
These concerns are not restricted to investors. Emerging market governments are also worried. During the recent bond market sell-off, emerging market currencies and bonds were smashed. In Quarterly Commentary 3, 2012, we noted the big investment story was not what was happening in Europe and America; it was the slowdown in emerging markets. This story continues to evolve.
It is notable that three important countries that have recently been under pressure – India, Brazil and South Africa – all face similar problems: inflexible economies inhibited by government regulation; infrastructural problems; government deficits and an adverse balance of payments.
All are now subject to sceptical scrutiny by investors. These countries are calling for the US to temper any changes to policies that have previously encouraged investment flows into emerging markets, in the hope that this will ease the pressures they are currently experiencing.
Now is the time for the quantitative easing and zero interest rates to end.
The process may be accompanied by market turbulence. However, this will be a small cost compared with the potential benefit of a return to normal asset pricing. In the long run, economic growth is driven by improving productivity. This requires an efficient allocation of capital. Mispricing asset markets inhibits this and prevents the economy from achieving its full potential.
The ending of QE should represent the start of a return to normal. However, there is a possibility that central banks have acquired a taste for dramatic policy intervention, seeing their role as being more than the custodians of financial stability. As a consequence of a long history of disastrous political intervention in monetary policy in many countries, central bank independence is regarded as a necessary feature of a well-functioning financial system. Following the crisis, many central banks have taken advantage of their independence to stray far beyond their normal remit.
They would argue that circumstances required this. It is going to be difficult to convince markets they will abandon their newly found penchant for radical initiatives. Despite the Fed’s forward guidance, the uncertainty regarding future US monetary policy continues. Its decision at its September meeting to postpone tapering compounds this uncertainty.
* Sandy McGregor is a portfolio manager for bonds of segregated individual clients at Allan Gray.