US Federal Reserve Chairman Ben Bernanke may finally announce today that he is about to start weaning the world off quantitative easing (QE). If so, no one can claim to be surprised. He has spent the past four months carefully laying the groundwork for the idea that the Federal Reserve’s monster bond-buying spree can’t last forever.
Most Fed-watchers believe any first move towards “tapering” is likely to be symbolic, rather than drastic: perhaps a US$10 billion or US$15 billion reduction in the size of monthly spending on US Treasury bonds and mortgage-backed securities.
Tapering would be a vote of confidence: The US housing market appears to have turned and new jobs are being created at a steady rate. However, a decision to start withdrawing the drug of super-cheap money is also a recognition that, as the Bank of International Settlements warned recently, it may be doing more harm than good.
QE on the unprecedented scale unleashed by the world’s central banks since the 2008 crisis was always a vast and risky experiment. Withdrawing it is the next, equally untried, step and there are hazards on all sides. It could go wrong in at least four ways.
First, while Bernanke plans to control the process carefully (that’s why it’s called a taper), markets trade on prediction and extrapolation and tend to run ahead of themselves. The moment tapering is under way, there is always a risk that investors will “run for the door,” as the IMF put it earlier this year — dumping bonds, forcing up interest rates and choking off the recovery.
The second risk relates to another current in the market: the so-called “commodity supercycle.” Russell Jones of Llewellyn Consulting suggested last week that, with Chinese growth easing, there is early evidence that the supercycle may be coming to an end.
While it has been impossible to disentangle the influence of QE from other causes of high raw-materials prices in the past couple of years, it seems certain that at least some of the billions poured into Wall Street must have found their way into commodity speculation. If the “supercycle” turns, Jones argues, central bankers could find themselves confronting the risk of deflation with few tools left to fight it.
Third, on the flipside, tapering may be so modest that it will barely be noticed by consumers and businesses out in the real economy. If confidence continues to flood back, reawakening Americans’ animal spirits, the Fed could find itself rushing to catch up as inflation takes off. While it can ratchet up interest rates rapidly, flogging off trillions of dollars’ worth of assets to suck cheap money back out of the economy cannot be done overnight.
Monetary policy is always a balancing act, but as HSBC’s chief US economist Kevin Logan pointed out last week, after collecting assets for much of the past five years the Fed’s balance sheet, at close to US$3 trillion, is now so huge as to create problems of its own — not least the risk of sustaining huge losses if bond prices plummet. Indeed, he suggested that this concern may contribute to any decision to taper this week.
“As time goes on, the balance-sheet costs and risks increase. That gradually lowers the bar for what is acceptable in terms of progress on job gains and economic growth,” Logan said.
The fourth reason to be wary — as has already been vividly illustrated by the chaos inflicted on a succession of emerging markets since tapering was first mooted in May — is that there are likely to be painful unintended consequences thousands of miles away.
India, Indonesia, Turkey, Brazil: Governments across the emerging world have been battling to contain the risks of a full-blown financial crisis as the hot money that poured in as a result of QE drains back out again. To some extent, it is not Bernanke’s job to worry about that and it will be left to the IMF to clear up the mess with loans if the worst does happen. As the events of 2008 and 2009 showed so clearly, the inevitable consequence of globalization is that causation flows every which way through the world economy.
An isolated ripple or two in countries with specific, well-known challenges, such as India, might be containable (though devastating at home); a more widespread downturn among emerging economies would be likely to hit the US itself, potentially forcing the Fed to reverse course.
Bernanke’s successor is expected to be announced in the next couple of months. The frontrunner was once Larry Summers, the Ivy League professor who was a cheerleader for financial deregulation and had won US President Barack Obama’s support with his staunch defense of the president’s economic stimulus policies. However Summer’s withdrew from consideration for the post on Sunday.
For Bernanke, who built his reputation on studying the policy pitfalls that marked the runup to the Great Depression and the “lost decade” in Japan, it would be a neat swansong to announce the beginning of the end for QE, which he was instrumental in dragging out of the textbooks and into the real world.