A word of appreciation for this post from Bibek Debroy, a renowned economist.
@vrk100 Good piece.
— Bibek Debroy (@bibekdebroy) September 19, 2013
Summary:
The US Federal Reserve on 18 September
2013, at its Federal Open Market Committee (FOMC), decided to postpone its much
talked-about tapering for the time being. This means the US Fed is maintaining
its status quo of buying bonds worth $85 billion per month. It’s not clear when
the Fed will start its tapering. With this flip-flop, the US Fed has made it
difficult to predict when it will gradually reduce its bond buying program. Due
to the moderate economic growth, low labor participation and recent rise in
mortgage rates, the Fed has decided to postpone the tapering decision. With
this decision, the US dollar is down, gold price is up, and stock markets too
have cheered the Fed decision.
What is Fed Tapering?
Before
we move further, let us see what is meant by Fed tapering. Tapering means to
reduce gradually. In May this year, the Fed had hinted that it would decrease
its monthly bond buying program (See more on QE3 at this end of this post) at a
measured pace. At that time it was
perceived that the tapering would start in September this year and would end by
the middle of 2014. The markets had taken this news of US Fed tapering very
negatively. Even though attempts were made to assuage the markets subsequently,
the market perception did not change. The US Fed, the IMF and the ECB tried to
calm the nerves of financial markets, by saying that they’d continue with their
easy money policies as long as their economies remain weak.
This Fed’ hint of tapering its bond
buying created a flutter in the financial markets. The yield of US EMs back to the
developed markets. Against the US dollar, currencies in the EMs
have depreciated very sharply—ranging from eight to 12 per cent.
Why the Fed postponed the
tapering?
As clarified by the Fed chairman Ben Bernanke there
are three main reasons for its decision to continue with its bond buying and
postpone the tapering:
1. Labor force
participation rate has declined—partly reflecting potential workers getting
discouraged. Though the unemployment has fallen to 7.3 per cent, the fall is
substantially due to people leaving the labor force.
2. There is a
tussle in the US congress
over passing of a bill to keep the government funded (if there is no agreement
between the Republicans and the Democrats, it may lead to a government shutdown
in the US
3. Mortgage
rates in the US
The
status quo remains for now:
As far as the financial markets are
concerned, the status quo remains for the time being. There is no change in the
QE. The Fed will continue with its buying program at the current levels. In the
words of FOMC:
“However,
the Committee (FOMC) decided to await more evidence that progress will be
sustained before adjusting the pace of its purchases. Accordingly, the
Committee decided to continue purchasing additional agency mortgage-backed
securities at a pace of $40 billion per month and longer-term Treasury
securities at a pace of $45 billion per month.”
This implies that the US
What is the state of the US
The US
In the last one year, unemployment rate
has fallen from 8.1 percent to the current 7.3 percent and about 2.3 million
private-sector jobs have been created. One of the reasons for dip in the unemployment
rate is the decline in labor force participation rate owing to people exiting
the workforce.
When will the
Fed start its tapering?
Between
May 22nd this year when the Fed hinted at tapering and now, the
financial markets—bond, stock, currency and commodity—have undergone immense
volatility. EMs were subject to large outflow
of funds. The Fed decision not to taper has taken the financial markets by
surprise. In the last 12 to 14 hours, the global stock markets have gone up
thinking that the Fed stimulus will increase fund flows into financial markets
and EMs .
The
tapering decision is now postponed. What lies ahead? When will the Fed start
reversing its easy money policy? What is the timeline for the Fed to start
raising the federal funds rate? The answers remain elusive. The Fed’s
about-turn is bound to confuse the markets, making it difficult to forecast the
future Fed decisions. The
Fed will keep its focus on US
The Fed’s
projections indicate the US
Overall,
the Fed is expecting a moderate recovery in the US US
When will the Fed start
increasing the fed rate?
Another persistent and relevant question
that bothers the markets is when the Fed will start increasing the fed rate.
The fed rate has been kept at a record low of 0 to 0.25 percent since December
2008.
The Fed has linked its bond buying
program to the outlook for the labor market. So, any decision on a tight money
policy, that is raising the federal funds rate, will depend on the labor market
conditions. The Fed is committed to continuing the fed rate at record lows as
long as the unemployment rate remains above 6.5 percent, and so long as
inflationary expectations are well under Fed’s comfortable levels.
The Fed is categorical that a decline in
the unemployment rate to 6.5 percent would not lead automatically to an
increase in the fed rate. Once the unemployment rate goes below 6.5 percent, it
will take a decision on the revision of fed rate keeping in mind the overall
economic outlook and labor market conditions, especially job gains. In the
words of the US Fed:
“…the
first increases in short-term rates might not occur until the unemployment rate
is considerably below 6.5 percent.”
Market Reaction:
The
US Fed's decision has been welcomed by the world’s financial markets. The market
perception is that the money taps will continue to be kept open by the central
banks. The US
The
US dollar is down, while gold and oil prices are up.
Conclusion:
The Fed has flagged certain fiscal policy
problems for the US US
The fact that the Fed will continue to
print money seems to have cheered the markets. However, there is one dissenting
voice in the FOMC. Ester George, one of the FOMC members has cautioned that the
massive bond buying program may result it future economic and financial
imbalances and higher inflation.
The real problem is that the markets may
react violently again when the Fed decides to start tapering. In fact, the
admission that the US
I think market will have to realize the
larger picture at some point in future. The
reality is that one day these central banks have to stop their massive
liquidity injection programs, resulting in large money outflows from emerging
to developed markets.
We need to
keep our focus on the ensuing economic indicators.
References:
Photo
courtesy: US Federal Reserve.
Abbreviations:
BoJ – Bank of Japan
DMs – Developed Markets
ECB – European Central Bank
IMF – International Monetary Fund
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Additional Reading
I. What is QE3?
After the 2007/2008 global financial
crisis, the Fed has been trying to stimulate the US
This is aimed at decreasing interest
rates and boosting the US
In the first round of quantitative easing (QE1)
between November 2008 and March 2010, the Fed bought MBS worth $1,250 billion
and agency MBS worth $175 billion, in addition to purchase of US Treasuries. In
the second round (QE2) between November 2010 and June 2011, the Fed bought US
Treasuries worth $600 billion. Officially, the QE program is known as large
scale asset purchases or LSAPs. In layman’s lingo, the QE has increased money
supply by leaps and bounds in the banking system, resulting in massive printing
of US dollars. This tremendous liquidity has flown out of the US
II. What monetary policy tools are used by the US Federal Reserve?
In normal times the Fed eases monetary
policy by lowering its target for the short-term policy interest rate, known as
the federal funds rate, or fed rate. For more than 50 years, the Fed has used
the fed rate as a conventional monetary policy instrument. In December 2008, the Fed
decreased the fed rate to a record low of 0 to 0.25 percent. After that, the
Fed was forced to use other unconventional tools at its disposal, due to the
fact that current federal funds rate of 0 to 0.25 per cent could not be lowered
further. So, how could the Fed signal interest rates in the economy?
Since the latter part of 2008, the Fed
has been using the following two tools:
1. Large scale asset purchases, commonly
known as quantitative easing, whereby the Fed has been buying US Treasuries,
MBS and others; and
2. Forward guidance about short-term
interest rates; that is, communicating its plans for setting the fed rate
target over the medium term.
III. What is the mandate of
the US Fed?
As per the Federal Reserve
Act, the statutory objectives for monetary policy are: maximum employment,
stable prices and moderate long-term interest rates. The Fed tries to target
inflation rate at two percent. Further, the objectives of the monetary policy
should be explained to the public as clearly as possible fostering better
communications; enhancing transparency and accountability; and reducing
economic and financial uncertainty.
IV. Why is US
Even though the Fed has increased its
balance sheet by almost four times in the last six years, there has been no
alarming increase in the US
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Disclaimer: The author is an investment
analyst, equity investor and freelance writer. This write-up is for information
purposes only and should not be taken as investment advice. Investors are
advised to consult their financial advisor before taking any investment
decisions. He blogs at:
The US Fed is making a fine distinction between "thresholds" and "triggers."
ReplyDeleteIn his press conference on 18Sep2013, Chairman Ben Bernanke said: "As I have noted frequently, the economic conditions we have set out as preceding any future rate increase are thresholds, not triggers. For example, a decline in the unemployment rate to 6½ percent would not lead automatically to an increase in the federal funds rate target, but would, instead, indicate only that it had become appropriate for the Committee to consider whether the broader economic outlook justified such an increase. The Committee would be unlikely to increase rates if inflation were projected to remain below our 2 percent objective for some time, for example; and, in making its assessment, the Committee would also take into account additional measures of labor market conditions, such as job gains. Thus, the first increases in short-term rates might not occur until the unemployment rate is considerably below 6½ percent."