With equity markets reacting enthusiastically to the Fed’s historic policy change announced last week, many have rushed to declare victory. Whether in asserting investor comfort with the policy regime shift or in declaring the definitive end of dependence on quantitative easing (“QE”), they believe that the markets’ short-term reaction can indeed be extrapolated into the longer-term.
Compare this with what we have been hearing from central banks. Reactions there have been quite muted. Humility may well be a factor, especially given that three prior attempts to “exit” earlier versions of QE regimes had to be abandoned. But there may well be more at play. Central bankers have good reason to be more cautious about declaring victory at this stage. And the rest of us would be well advised to ask why.
As widely reported last week, Fed policy makers decided to reduce – or “taper” – the purchases of securities. The first step, to be implemented in January, lowers the monthly market intervention from $85bn to $75bn by cutting equally both mortgage and Treasury purchases. Moreover, Ben Bernanke, outgoing Fed Chairman, signalled that – assuming there are no major economic surprises – we should expect the Fed to consistently reduce its purchases throughout 2014. So much so that, if all develops according to plan, the Fed could well terminate QE3 by the end of the coming year.
Unlike between May and June when the mere mention of the word “taper” severely disrupted markets, the Fed’s announcement this time did not stop just at taking away a measure that is widely believed to have significantly bolstered asset prices and, to a lesser extent, helped the real economy too. Our central bankers adopted compensating measures by providing greater assurances that policy interest rates would remain floored for quite a while. They have also hinted at additional measures should interest rates behave erratically – such as cutting the interest that the Fed pays banks on excess reserves.
Equities and other risk assets have soared in reaction to the news. After all, investors now have a clear road map for Fed policies, thus reducing a component of the uncertainty premium. Moreover, it is highly reassuring that the Fed remains committed to supporting the economy through the “asset channel.” And all this is taking place in the context of an improving economy as evidenced by the strong employment report and the upward revision in GDP growth.
While most Fed officials will welcome the markets’ favourable reaction – and especially so after the May-June shock – I suspect that they are much more cautious. Indeed, there are four reasons why such caution is understandable.
First, the impact of Fed policy remains overly dependent on using artificially-high asset prices to alter household and company economic behaviour. Other transmission mechanisms, including the credit channel and the deployment of cash in real economic investments, remain muted. Accordingly, concerns about financial soundness will persist until the Fed witnesses improving economic fundamentals that validate artificially-elevated asset prices.
Second, the Fed is entering a more uncertain policy phase due to its ongoing instrument pivot – namely, less reliance on a direct measure (monthly purchases) and greater reliance on an indirect one (impacting behaviour through forward policy signals). Issues regarding the degree of effectiveness and control could well come to the fore. Just witness the recent sharp upward moves in the 5-year US Treasury yields, along with other intermediate maturities.
Third, those at the Fed who follow closely market positioning will probably recognise that equity markets are currently in the grips of very favourable technicals; and, judging from history, such technicals can lead to price overshoots whose reversal can be quite disruptive.
Finally, the Fed is not the only central bank that has been active in maintaining economic and financial tranquility and, to this end, continuously bolstering asset prices; and it is not the only institution that has been forced to rely on imperfect instruments to fulfil this task.
The European Central Bank and the Bank of Japan are in the same boat. And they, too, face tricky policy issues ahead, with success also ultimately dependent on the overall ability of their economies to overcome the trio of inadequate aggregate demand, insufficient supply responsiveness and residual debt overhangs.
After a couple of false starts, Fed officials have impressively won the first big battle in implementing a gradual orderly exit from QE3, a highly-experimental measure whose longer-term consequences are not fully known as yet. They are yet to win the war.