In the presence of unconventional measures and an unfamiliar macroeconomic environment, market sensitivity to policy movements is at its peak. To minimise volatility caused by tapering of quantitative easing (QE), the Federal Reserve (Fed) must continue to effectively communicate its expected path of policy going forward.
QE has been the largest monetary experiment ever seen. The Fed recently announced a slowdown in the pace of its asset purchases, currently at $65bn per month from its peak of $85bn. This is only a second-order reduction and the Fed’s monetary stance remains highly accommodative.
Is the U.S. economy ready to weaned off QE? There remain too many unknowns to accurately answer this question. The degree of slack in the economy, the amount of cyclical versus structural damage from the crisis, the extent to which QE is supporting a recovery. Like most major economies, the U.S. currently finds itself in an unfamiliar macroeconomic environment.
There is evidence that a recovery is in motion. Unemployment is down to 6.6%, although equally driven by falling participation as increasing jobs. Output grew 3.2% in the final quarter of 2013 despite the government shut down, fuelled by both household and business spending.
However there remain a number of reasons to believe QE still has a role to play in fuelling a recovery.
Firstly the possibility of ‘secular stagnation’, raised by Larry Summers at an IMF conference last November1. The argument goes that the U.S.’s equilibrium interest rate is negative; consequently the supply of savings is greater than the demand for investment. In this case the zero lower bound inhibits equilibrium from being achieved. In current context this could be preventing an escape from the subdued demand causing low economic growth.
If this is a correct diagnosis of the U.S. economy then the exit from QE would be premature, and indeed any exit from QE would be unwarranted, as monetary policy would be required to continuously operate beyond its conventional interest rate tool to stimulate demand.
The other issue is the endogeneity of supply, which has been at the forefront of central bank’s post-crisis thinking. The degree to which demand creates its own supply is fundamental to assessing the amount of slack in the U.S. economy and its ability to grow in the future.
A paper by the Fed2 estimated U.S. potential GDP at 7% below that implied by its trajectory pre-crisis, arguing a lot of the damage has been endogenous to the weak demand experienced post-crisis. This highlights a clear shift in the Fed’s thinking, with supply shocks previously defined as exogenous and beyond the control of monetary policy. They argue monetary policy can play an activist role in maintaining demand, in turn supporting the supply-side of the economy.
However the paper stops short of prescribing infinite QE and forever-low interest rates due to its implications for financial stability. Indeed given the current slack in the economy and low inflation, concern for financial stability is the greatest driver behind QE tapering.
The degree to which asset prices are being driven by QE remains unclear. The cyclically adjusted price to earnings ratio is above its long-term average and almost back to its pre-crisis level, suggesting prices are currently inflated. Also, like the rest of the economy, it is unclear whether the financial sector is ready to support a QE-less recovery.
QE undoubtedly played a large part in 2013’s bull market, with the S&P 500 gaining over 31%. The extent to which QE is a driver will be seen in 2014, with the Fed planning on winding down QE by the end of the year. If this leads to large sell-offs and price corrections, this will have significant consequences for broader economic confidence.
The financial sector has been the largest beneficiary of QE, gaining from its effect on asset prices and confidence levels. However the damage wrought by the crisis on the financial sector, particularly the major banks, exposed huge flaws in the structure of the system. QE-inflated asset prices have helped banks rebuild their balance sheets but this may have masked the true extent of repairs done.
Reinhart and Rogoff3 showed financial crises to be the most destructive causes of recessions. Without a fully functional financial system resource allocation is impaired. If the winding down of QE reveals a lack of sufficient capital in major banks or a greater number of non-performing loans than previously believed, this will send shockwaves through the economy.
Overall the stability of the U.S. economy in the wake of QE’s exit will depend on the two questions raised; is the economy ready to be weaned off QE, and to what extent has it been propping up the financial sector? The Fed has made the judgement that it is time to taper QE over the course of 2014. Ultimately the market will decide how far QE has taken prices from their fundamentals and therefore how much of a correction will take place.
So far the taper has been gradual and well communicated, with surprisingly little domestic volatility. The subsequent performance of the economy as this continues will be subject to increased scrutiny, with any major movements in key U.S. data releases having the ability to shift market expectations of the policy path. The Fed must remain transparent and predictable in order to avoid such instability.
The effect of possible spillovers from QE has sparked a fierce debate amongst global policy makers. These unintended consequences are yet to be fully understood by the Fed and could cause significant political tension for the U.S. if not appropriately addressed.
The start of 2014 quickly saw volatility in emerging markets, with a number witnessing their currencies depreciate substantially. Tensions rose when the Fed continued tapering in January, failing to even acknowledge these events.
Not all of those countries affected are major trading partners with the U.S. (Canada, China, Mexico and Japan make up almost 50% of U.S. trade exposure). As Paul Donovan recently argued4, direct trade is not a useful measure of exposure to these countries. Instead trade in value-added provides a better insight into the role these countries play in the U.S. economy, showing it to be relatively small.
The countries that have failed to implement appropriate reforms over the last few years are those that are currently suffering the most. The conditions provided by QE have removed the immediate need for structural reforms. Countries like Argentina, Turkey, India and South Africa have run either large current account or budget deficits, or both. In this way QE is being used as a scapegoat for the lack of reforms that are politically challenging to implement.
However, as was seen back in the late 1990’s during the South East Asian Crisis, financial volatility originating in emerging markets has a contagious effect to which the U.S. is not immune.
Many commentators have quoted the Fed’s remit when debating whether it should take account of spillover effects abroad, declaring it is responsible for domestic inflation and employment. Volatility abroad feeds back into the U.S. via a number of channels, therefore even when only considering domestic targets it must take into account the feedback from external effects, a point well made by Willem Buiter5.
Beyond this, the U.S. occupies a position of great privilege and responsibility as the owner of the world’s reserve currency. It cannot take advantage of all the benefits this affords it, such as the ability to run a consistent current account deficit or raise large amounts of cheap debt, without also recognising the influence its policy decisions have on the rest of the world.
Ultimately the Fed’s monetary policy decisions will be based on what is best for its domestic economy, it would be naïve of anyone to expect otherwise. However by not displaying greater international cooperation, the Fed risks repeating the mistakes made leading up to the crisis. Policy makers grossly underestimated the degree of interlinkages between global markets in the lead up to the crisis, which appears forgotten by the Fed.
Overall, given the rapid expansion of the Fed’s balance sheet since the crisis, it is unlikely QE tapering will occur without some levels of economic and financial volatility. A large part of the instability seen post-crisis has been driven by uncertainty and this will continue to be the case as the full effects of this unconventional monetary policy gradually emerges.
This part of the exit is largely beyond the control of the Fed. Going forward the Fed can only look to optimise its exit path from here and avoid any policy-driven shocks. Central to achieving this is continued, effective communication of the expected path of policy. The Fed is still not advanced enough in its thinking about how market players react to certain events to able to effectively forecast outcomes of isolated policy movements, particularly in the current environment of heightened market sensitivity. The best option for the Fed is to ‘lay its cards on the table’ and enable markets greater certainty when forming their expectations, both at home and abroad.
1) Larry Summers- IMF Jacques Polak Conference (http://bcove.me/64y4ydjk)
2) D. Reifschneider, W. Wascher & D. Wilcox- Federal Reserve (https://www.imf.org/external/np/res/seminars/2013/arc/pdf/wilcox.pdf)
3) C. Reinhart & K. Rogoff- NBER (http://www.nber.org/papers/w14656)
4) Paul Donovan- Reuters (http://blogs.reuters.com/india-expertzone/2014/02/14/why-the-fed-is-not-...)
5) Willem Buiter- FT (http://www.ft.com/cms/s/0/fbb09572-8d8d-11e3-9dbb-00144feab7de.html?site...)