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
The package of quantitative easing announced today by the new regime at the Bank of Japan is one of the largest monetary injections ever announced by the central bank of a major developed economy. The only rival for that crown is the emergency easing in monetary policy which took place in most economies in late 2008. But today’s BoJ action has not been driven by any short-term emergency. It represents a deliberate change in philosophy, and a complete abandonment of everything that the Bank of Japan has said about monetary policy in the past two decades. Those who believe in quantitative easing certainly have their experiment, writ large in Tokyo.
In effect the new governor, Haruhiko Kuroda, has imported into Japan the whole of the Federal Reserve’s post-Lehman balance sheet strategy, and he will implement it in under two years, instead of the five years or more taken by the Fed. The doubling in the Japanese monetary base over a period of 21 months is in itself remarkable. Taken together with the extension of the duration of bonds purchased from less than 3 years to an average of 7 years, the injection becomes of historic proportions.
The new strategy brings, for the first time, a real prospect of breaking the deflationary psyche which has plagued Japan for so long. But it also brings risks that the strategy might work too well, with inflation expectations unhinging the bond market. Mr Kuroda is trying to pull off a difficult trick, which is “to drastically change the expectations of markets and economic entities”, and to do so in a very particular way. Read more
The FOMC will meet on Wednesday with the markets feeling confident that there will be no change in monetary policy. This means that the $85bn per month rate of balance sheet expansion will probably remain in place. But recently chairman Ben Bernanke has conceded, rather reluctantly, that the Fed’s exit strategy from quantitative easing will soon need to be reconsidered by the committee, and the debate could start at this month’s meeting. In any event, with economists now upgrading their forecasts for US GDP for the first time in quite a while, the markets are increasingly focused on whether the exit can be handled successfully.
The first question is whether the exit will be gradual or abrupt. The chairman’s personal preference is very well known: it should be gradual, and extremely well flagged in advance. But Mr Bernanke might not be in office after next January, and there are others on the FOMC who could have different ideas. Furthermore, economic and market circumstances could change. In 1994, GDP growth and inflation both rose markedly, and the Fed slammed on the brakes without any warning. The resulting 3 per cent rise in the Fed funds rate delivered a major shock to the financial system. 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
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
Ben Bernanke has boldly gone where no Fed chairman has gone before him with his third round of quantitative easing. Gavyn Davies discusses with the FT’s Long View columnist John Authers why Mr Bernanke has chosen this path – and its risks:
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
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
Ben Bernanke has been very focused on the Fed’s “communications strategy” for several years now, and has patiently pushed the FOMC in his desired direction during a series of detailed discussions. Now it seems that he has reached his destination, and will reveal all (or almost all) in his press conference after the FOMC meeting which begins on Tuesday. Always a fan of explicit inflation targets, the chairman seems finally to have won agreement from colleagues on establishing a formal objective for core inflation of about 2 per cent, though the FOMC will also need to keep Congress happy by talking about its long term unemployment objectives as well. More unconventionally, each member of the FOMC will also publish for the first time their projections for the Fed funds rate extending to 2016.
What is the motivation behind these changes? Mr Bernanke has normally justified such steps in terms of stabilising expectations about the Fed’s genuine intentions, especially on inflation and the forward path for interest rates. At a time when the extension of the balance sheet is causing political difficulties for the Fed, and when inflation expectations could become unhinged by the rapid expansion of the monetary base, the chairman is looking for alternative ways of easing monetary conditions without printing more money. Modern macro-economics suggests that operating on expectations is one of the most powerful tools available to him, though he is using it much more cautiously than many economists would like to see. Read more
Gavyn Davies is a macroeconomist who is now chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners. He was the head of the global economics department at Goldman Sachs from 1987-2001, and was chairman of the BBC from 2001-2004.
He has also served as an economic policy adviser in No 10 Downing Street, an external adviser to the British Treasury, and as a visiting professor at the London School of Economics.
Gavyn Davies is an active investor and may have financial interests and holdings in any of the topics about which he writes. The views expressed are solely those of Mr Davies and in no way reflect the views of Prisma Capital Partners LP, Fulcrum Asset Management LLP, their respective affiliates or representatives. This material is not intended to provide, and should not be relied upon for, investment advice or recommendations. Readers are urged to seek professional advice before making any investments.