In the past decade, the world’s central banks – first in the emerging and then in the developed world – have embarked on a Great Expansion in their balance sheets which is unprecedented in modern times. This blog sketches the anatomy of the Great Expansion and attempts to project what will happen as the US Federal Reserve tapers its asset purchases in the next 18 months.
The latest episode in the saga has, of course, involved the Fed’s attempt to distinguish between “tapering” and “tightening”, a distinction which the markets have been reluctant to recognise . The US forward interest rate curve shows the first rate increase occurring very close to the time when the Fed is planning to stop buying assets in mid-2014. Whether it intended to do so or not, the Fed has de facto tightened US monetary policy conditions and will have to work hard to reverse this. Read more
On Wednesday, the chairman of the Federal Reserve announced that the greatest experiment in the history of central banking might be nearing its end. Ben Bernanke’s announcement included many caveats, but the financial markets did not miss the message. Since 2009, the central bank has been buying financial assets – US Treasury bonds and some types of corporate debt – paid for by an expansion of the monetary base (so-called “printing money”). This kept interest rates low, which damaged savers but helped indebted businesses and households. It has also been the major prop for financial markets. Within about a year, if the Fed’s plans come to fruition, the US government deficit will need to be financed from private sector savings – not by the central bank. Asset markets will be left to fend for themselves as the biggest buyer withdraws from the arena.
That is why some hedge funds sold off bonds this week, causing a big drop in their prices – the flipside of which is a rise in borrowing costs (or “yields”). Mr Bernanke has expressed consternation that adjustments to the path for the Fed’s balance sheet, such as the one he announced this week, can have such a profound effect on the bond market. But investors are making logical inferences from central bank behaviour. The Fed does not change direction often. When it does, tightening often comes in a rapid series of interest rate rises that are not fully anticipated by investors. Read more
When we look back on the FOMC meeting on June 19 2013, it will probably be seen as the moment when the Fed signalled that it was beginning the long and gradual exit from its programme of unconventional monetary easing. The reason for this was clear in the committee’s statement, which said that the downside risks to economic activity had diminished since last autumn, presumably because the US economy had navigated the fiscal tightening better than expected and the risks surrounding the euro had abated.
This was the smoking gun in the statement. With downside risks declining, the need for an emergency programme of monetary easing was no longer so compelling. The Fed has been the unequivocal friend of the markets for much of the time since 2009, and certainly ever since last September. That comfortable assumption no longer applies.
Fed chairman Ben Bernanke, however, went to great lengths to mitigate the hawkish overtones of this message in several respects. The asset purchase programme would be ended only when the US unemployment rate has fallen to 7 per cent, which the central bank expects to happen by mid-2014, he said. In the meantime, the pace of asset purchases could be increased as well as reduced, depending on the incoming economic data. Read more
Central bankers nowadays have the power to move the global markets by uttering nothing more than a brief, off-the-cuff remark. “Whatever it takes,” was Mario Draghi‘s version, which saved the euro last year. “In the next few meetings,” was Ben Bernanke’s equivalent last month. There will be rapt attention turned on the Fed chairman’s press conference on Wednesday to see whether he retracts that remark, which of course relates to the time when the Fed might start to slow the pace of its asset purchases.
Mr Bernanke does not carelessly throw out such remarks, so it would surely be incoherent for him to withdraw it completely this week. The Fed is unlikely to have been particularly troubled by the bout of market volatility seen lately. Much of it has come in foreign markets, which are not the Fed’s responsibility. Meanwhile, in the US itself, the reversal of the “reach for yield” is precisely what the Fed has been wanting to see for several months.
The killer phrase “in the next few meetings” is therefore likely to remain on the table after the press conference on Wednesday. However, the Fed chairman will hammer home exactly what he means by this message, since there are signs that it has been misunderstood by investors. In particular, the US Treasury market is sending some messages which should worry the Fed. Read more
The month just ended was the fourth worst month for government bond returns in the past two decades. This abrupt response to Ben Bernanke’s warning that the Fed might think about tapering QE at some point in the next few meetings has naturally raised fears that the great bull market in fixed income, which started in 1982, might now be threatened by a sharp reversal.
Some analysts regard this as the inevitable bursting of a bubble which has been created by the actions of the central banks (see this earlier blog). Others, like Jim O’Neill, regard the rise in bond yields as the start of a return to economic normality, and argue that would be a very good thing as long as it occurs in an environment of recovering economic confidence. Paul Krugman also points out that the pattern of behaviour in the major markets – bonds down, dollar up and equities up – is consistent with greater optimism about the US economy, rather than worries about the Fed or the onset of a debt crisis. Read more
The volatility in financial markets since Mr Bernanke gave evidence to Congress yesterday is a not-so-gentle reminder of what might happen when the Fed eventually begins to withdraw monetary accommodation. The Chairman’s warning that the FOMC might reduce the pace of its asset purchases “in the next few meetings” has clearly spooked the markets, especially those (like Japanese equities) where bullish positions had become very crowded.
The Fed’s main message at present is that it will “increase or reduce the pace of its asset purchases…as the outlook for the labor market or inflation changes”. This seems deliberately designed to inject some uncertainty into market psychology, and thereby prevent an excessive risk taking. Mr Bernanke said that he takes the risk to financial stability “very seriously”.
But the overall tone of the Chairman’s written evidence yesterday strongly suggested that the Fed is still a long way from contemplating any significant change in monetary policy. After all, tapering QE would only imply that the pace at which policy is being eased is being reduced. An outright tightening of policy still seems to be several years away. Read more
Professor Jeremy Stein is a much respected financial economist from Harvard who in May became a member of the board of governors at the Federal Reserve. Until last week, the markets had paid him relatively little attention, but that is now destined to change. The important speech he delivered in St Louis on Thursday about credit bubbles differed significantly from one of the main planks in the Bernanke/Greenspan doctrine of the past 15 years. It does not have immediate policy implications, but it could easily do so within two years.
The speech, which is nicely summarised here by Matthew Klein at The Economist, deserves to be read in full by all market participants. (One member of the FOMC told me last week that the speech was “geeky”, but that was intended, and taken, as a high compliment!)
In summary, the speech argues that the credit markets have recently been “reaching for yield”, much as they did prior to the financial crash. Although not yet as dangerous as in the period from 2004-2007, this behaviour is shown by the rapid expansion of the junk bond market, flows into high-yield mutual funds and real estate investment trusts and the duration of bond portfolios held by banks.
Governor Stein suggests (hypothetically) that this may become a policy headache within 18 months and, in a break with the Bernanke/Greenspan doctrine, he indicates that the right weapon to deal with this might well be to raise interest rates, rather than relying solely on regulatory and other prudential policy to control the process. This would obviously come as a big surprise to the markets, which have tended to view the Fed’s stated concerns about the “costs of QE” as so much hot air. Read more
The chairman of the Federal Reserve Ben Bernanke. Getty Images
There have been three important developments in central banking in the past week, which together indicate that their approach to inflation targeting, one of the few features of pre-2007 policy orthodoxy that has survived the financial crisis, may now be subject to radical change. (See Robin Harding on the “quiet revolution” at the central banks.) It is greatly premature to declare that inflation targeting is dead, but things are clearly on the move.
In the UK, the incoming Bank of England governor Mark Carney has suggested nothing less than the abandonment of the short-term inflation objective altogether, and has mooted the possibility of a nominal GDP level target, which is a beast with very different stripes. In Japan, the new Abe government intends to impose a higher (2 to 3 per cent) inflation target on the central bank, which can probably be hit only by pushing the yen lower.
In the US, there has been a clear shift in the Fed’s policy reaction function, or “Taylor Rule”, increasing the weight placed on unemployment and reducing the weight on inflation. The nature and importance of the Fed’s policy shift has not yet been fully understood, because it was not really spelled out by Chairman Bernanke in his press conference this week. Read more
Professor Michael Woodford of Columbia University is an extremely renowned macro-economist, and rightly so, but only recently has he occupied a central place in market thinking. Since his paper on US monetary policy at Jackson Hole, and the favourable remarks which Ben Bernanke made about him, everyone is trying to understand what his influence on the Fed might eventually mean.
His writing can be complex and intricate, which is in the nature of the subject, but his current policy recommendation is quite clear: the Fed should adopt a target for the level of nominal GDP which would have the effect of increasing price inflation, and inflation expectations in the period ahead, and thus reduce the real rate of interest.
If the controlling majority which surrounds the chairman on the FOMC has fundamentally accepted the thinking which backs these recommendations, as many investors believe, then there has been a profound change in Fed strategy. However, I am not convinced that this is the case. Mr Bernanke has not yet crossed the inflation Rubicon. Read more
The looming fiscal cliff in the US has now replaced the actions of the Fed and the ECB as the major macro talking point in the financial markets. Although most investors expect that the American political system will find a way out of the large fiscal tightening which is currently scheduled to take place in 2013, there is a great deal of uncertainty about how and when this will be accomplished. In the meantime, concerns about the fiscal cliff have now clearly started to damage capital goods orders in the business sector, which last week dropped in a manner which is normally seen only in recessions.
The US economy remains fragile, and a large downward shock to capital spending, which now seems inevitable in the final quarter of the year, is certainly not what the doctor ordered. It may well lead to a further slowdown in GDP growth in Q4, from the already anaemic 1.8-2.0 per cent rate which seems likely for Q3. However, unless policy makers in Washington prove unable to break free of political gridlock after the elections on 6 November, it still seems improbable that the economy will slide into recession early next year. Read more
It is often claimed by economists that the central banks have run out ammunition to boost economic activity, but they certainly have not lost the ability to have an impact asset prices. Since the latest round of quantitative easing was signalled back in June (see this blog), global equity prices have risen by 14.5 per cent, and commodity prices are up by 15.4 per cent, despite the fact that economic activity data have shown no improvement whatever over this period.
Clearly, these impressive moves in asset prices have been triggered by a sharp decline in the disaster premia that were priced into markets only three months ago. Mario Draghi and Ben Bernanke have, in a sense, purchased global put options on risk assets, and have offered them without charge to the investing community.
By doing the market’s hedging for it, the central bankers have certainly had an impact. Confidence, while not fully restored, is much improved, which is exactly what was intended. But there is no sign yet from hard data that the downward slide in global GDP growth has been reversed. Until that happens, the market rally will remain on insecure foundations. Read more
Ben Bernanke. Image by Getty.
Ben Bernanke, Fed chairman, will speak about “Monetary Policy Since the Crisis” at the Jackson Hole Symposium at 10 am (EDT) on Friday. The markets have learned to focus intently on such occasions, since there is something in the clean air of Wyoming which seems to inspire Mr Bernanke. On several occasions in recent years, the tone he has adopted at Jackson Hole has set the trend in financial markets for many months to come.
This year, there are doubts about what the chairman might say. The markets have already assumed that a further monetary easing by the Fed is just around the corner, almost certainly to be announced at the next FOMC meeting on September 12-13. At the very least, this will probably involve an extension of the Fed’s guidance on “exceptionally low” levels for the federal funds rate from the end of 2014 at least to mid 2015.
However, there is uncertainty in the markets about whether the FOMC is minded to do anything more aggressive than that in September. That possibility was raised by the dovish set of minutes for the 31 July/1 August FOMC meeting which were published last week. The key question is whether Mr Bernanke will choose to clarify the ambiguities in these minutes in either direction. Read more
Keynes – image by Getty
The exact nature and effects of economic uncertainty are subjects which have played a central role in macroeconomic theory for several decades, especially in the work of Keynes and his followers. Uncertainty, as defined by Keynes, is thought by many to be capable of explaining all of the key events of the past five years, including the intractability of the recession in the developed economies. More unexpectedly, the concept has started to play a starring role in the US presidential campaign, though in a very different context from anything contemplated by Keynes.
When I first studied Keynesian macroeconomics in the early 1970s, Keynes’ thoughts on the nature of uncertainty, which appear most famously in Chapter 12 of the General Theory, were not thought central to his analysis of the Great Depression, or for his policy prescriptions. The writings of Paul Davidson changed that perspective in the 1980s, but the subject was still mostly viewed as a special topic for rather obscure debates among post-Keynesian theorists. None of this had mass appeal until the crash of 2008, and the work of Robert Skidelsky in 2009. Read more
The fall in US unemployment remains slow but with no clear deflationary threat the US Federal Reserve is in a quandary regarding the next steps in its monetary policy. John Authers, Long View columnist, asks Gavyn Davies, chairman of Fulcrum Asset Management, what Ben Bernanke, chairman of the Fed, is most likely to do next.
Risk assets rose slightly last week, and global equities are still trading within about 2 per cent of their highs for the year. The resilience of equities was slightly surprising in a week which saw both a disappointing set of US GDP data and a Fed policy statement which was on the hawkish side of expectations. Goldman Sachs’ economists commented that the US economy and financial markets are “moving into a tougher environment”, in which the economy is slowing and the Fed is shifting its policy reaction function in a less stimulative direction.
One reason why risk assets have remained firm recently, is that earnings in the latest company reporting season have once again been beating expectations in the US and the eurozone. According to Jan Loeys at JP Morgan, US corporate earnings per share for 2012 Q1 have come in 8 per cent higher than analysts’ expectations, while the drop in eurozone earnings has been 4 per cent less than feared. Clearly, corporate financial strength has been helping investment sentiment, but that would not persist for very long if the Fed really did change its tune on monetary policy. Read more
The minutes of the Federal Open Market Committee meeting on March 13 have surprised the markets. The committee seems to have shifted in a markedly more hawkish direction than was reflected in the statement issued after the meeting, and the bar to quantitative easing 3 now seems to be rather high. Perhaps we should have expected this, given the fact that speeches by chairman Ben Bernanke and Bill Dudley since the meeting had given no hint of any further easing. But the breadth of the committee’s shift away from easing was certainly not expected.
It is easy to find hawkish phrases in the minutes. The US Federal Reserve staff has not only upgraded its real gross domestic product projections, and increased its inflation forecasts, but has also reduced its estimate of the output gap. Only “a couple” of FOMC members saw any case for further easing, and then only if growth falters or inflation falls below target. There was even some discussion of changing the guidance on keeping short rates “exceptionally low” up to the end of 2014, a move which would really shock markets. Read more
As they meet today the Federal Reserve’s governors face a dilemma; with unemployment creeping lower while inflation rises, can they justify a third round of stimulative quantitative easing? Gavyn Davies, chairman of Fulcrum Asset Management, explains to Long View columnist John Authers that while the Fed is keen for QE3, it needs to bring inflation more under control first. (5m 27sec)
A large and important change is underway in global economic policy. This change will determine whether the developed economies can grow their way out of recession. Although the new strategy has been tried before by individual economies, this is the first time it has been adopted on such a global scale. If it fails, it is far from clear that policy-makers have a ready-made alternative plan waiting in the wings. Read more
The Bank of England meets on Thursday with expectations running high that the MPC will announce a further large dose of quantitative easing. Even if they pass this month, which seems possible, this is likely to be only a temporary postponement. Whenever it comes, the next move will be another bout of “plain vanilla” QE, involving the purchase of £50-75bn of government bonds, and taking the overall Bank of England holdings to over one third of the total stock of gilts in issue.
Meanwhile, the Fed is still debating whether to increase its holdings of long dated securities, and if so whether to focus once again on government debt, or to re-open its purchases of mortgages. Any further QE would be contentious on the FOMC, but there is probably still a majority in favour.
Central bankers, unlike many others, have not lost faith in the efficacy of QE. The vast majority of them not only believe that additional asset purchases can further reduce long term bond yields at a time of zero short term interest rates, but also that this can increase real GDP growth, compared with what otherwise would have occurred. Are they right? Read more
One of the great constants in the world economy in the past few decades has been the consistently strong growth in the US labour force. This has given American economic performance a demographic head start compared with other developed countries. Not only has it been the main factor ensuring that US GDP growth has remained well above that in Europe, it has also injected flexibility and dynamism into the US economy. But all of that is now at risk. The US labour force suddenly stopped growing in 2008, and has been falling slightly ever since.
As a result of this sudden disappearance of growth in the labour force, the unemployment rate has fallen by 1.5 percentage points in the past two years. But it is doubtful whether this represents a genuine tightening in the labour market. More likely, the underlying growth in the labour force has been disguised by the fact that potential workers have been discouraged from remaining in the labour market by the shortage of job opportunities. Without this shrinkage in the labour force, the unemployment rate would have risen to more than 11 per cent by now. It is urgent to fix this problem before the labour market atrophies, as it did in Europe in the 1980s. Read more