Friday, June 21, 2013

The QE exit - A teachable moment

Finally, the much-awaited unwinding of Fed's balance sheet has begun. Ben Bernanke's announcement of the tapering of the quantitative easing program shows that the Fed feels that the US economy is on a sustainable enough recovery path.

He said that the Fed would start tapering its $85 bn monthly pace of asset (treasury securities and mortgage-backed securities) purchases from later this year, and continue until the end of the program sometime in mid-2014 when the US unemployment is estimated to fall to 7 percent. He also said that the pace of tapering will be adjusted depending on the economic outlook. The Fed lowered its unemployment rate forecast for end-2013 from 7.4% to 7.25% and that for end-2014 from 6.7-7% range to 6.5-6.8%, while it raised the 2014 GDP growth expectations to 3.25%.

The Fed's gradual tightening would bring an end to the age of plentiful cheap liquidity, and naturally raise the price of capital, reflected in the interest rates. Institutional investors will look to repatriate a large amount of capital back to the US, both to shore up their margins in anticipation of higher interest rates and in the expectation of recovery improving domestic investment opportunities in the US. Accordingly, the markets worldwide have reacted with broad sell-offs, despite the widespread anticipation of the announcement. Equity markets have fallen sharply and bond yields have risen, in expectation of diminished liquidity support and a reduction in the demand for bonds. The yield on 10 year US Treasuries rose to 2.36%, its highest since March 2012, up sharply from 1.6% at the start of this May.

A few observations on the announcement and its possible implications.

1. The question foremost in everyone's minds will be whether the Fed has timed its exit too early. After all, both the economy and labor market are still weak, and the Fed's decision is premised on the "expectation", and not "certainty", that the economy is firmly on recovery path. But "expectations" are just that! The premature exit from monetary and fiscal accommodation by the Bank of Japan and the Japanese government in the late nineties is thought to have been responsible for prolonging the "lost decade" of deflationary recession in Japan. In the case of the US too, there exists the real possibility that the rates may rise too high and too soon that it will adversely affect the debt-laden governments, businesses, and households.

The US federal, and many state and local governments, are heavily indebted and the recent period of ultra-low rates had served to alleviate their real debt-burden. Since many household mortgages still remain underwater and the rising rates will put upward pressure on mortgage rates, the households with un-repaired  balance sheets will be adversely affected. Finally, businesses will find their cost of investments rising precisely at a time when recovery is likely to be taking hold. A confluence of some of these factors has the potential to nip the green shoots of recovery, just as what happened in Japan.

2. A big danger for the global financial markets will come from the generational shift that will arise in moving from an era of ultra-low rates and abundant liquidity to a more normal period, even one where liquidity may remain strapped for a prolonged period. Gillian Tett makes a very important point about the markets addicted to "cheap money and the carry trade". A generation of traders have seen only cheap and abundant capital and have internalized trading strategies that revolve around them. How will the markets react to the new era of scarcer and more expensive capital?

3. Fueled by the easy money policies of the past five years, the global financial markets have been showing ample signs of froth and bubbles. There is growing consensus that the ultra-low rates had induced several distortions into an already heavily distorted global financial markets. To this extent, the Fed's decision is equivalent to "taking the punch bowl away when the party is on". In other words, the Fed has made a conscious judgement call to puncture the ongoing boom in equity and bond markets, albeit motivated by different considerations.

4. The carefully phrased nature of the announcement on tapering QE is a continuation of the Fed's recently embraced policy of "forward guidance" to steer monetary policy and shape expectations. In simple terms, the fortunes of the US economy, and thereby the world economy itself, is in no small measure being guided by gymnastics with words. Bernanke's communication is obviously intended to cause the least disruption in the financial markets, and reassure investors that there would be a seamless unwinding of the Fed's massively bloated balance sheet. It makes one wonder what role professional communications specialists have had in helping formulate phrase the Fed's "forward guidance" policy? Indeed, every word in the Fed's statements are subjected to the most intense scrutiny to get the best possible interpretation of its intentions.

5. One cannot but not notice the relative lack of any sophisticated economic models in the Fed's decision, though doubtless some monetary policy model has informed the forecasts and the predicted trajectories. However we cannot say anything with any reasonable degree of certainty about how things will pan out in the foreseeable future. This is one of the more important teachable moments in macroeconomic policy making that we have seen since the bursting of the sub-prime mortgage bubble. By all the same arguments, the Fed could have delayed the exit by another six more months, announcing this only towards the later part of this year. To that extent, one can say that the timing, sequencing, and pacing of the exit is an informed judgement call by the FOMC.

6. Its impact on India is likely to be atleast mildly disruptive in the short-run. India's problems are exacerbated by the fact that it suffers a very high and rising current account deficit. The inevitable sell-offs in equity markets and capital flight will increase the downward pressure on the rupee. The RBI will be forced into keeping rates high, so as to discourage the foreign capital from fleeing, even if inflationary pressures appear to be subsiding. To this extent, there will be an important shift in monetary policy, which hitherto had been guided only by the trajectory of inflation. Now monetary policy will have to accommodate the need to both lower inflation as well as maintain stability in the exchange rate market.

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