In a previous article (‘QE3 is on the cards’, FE, June 25), I had indicated the reasons why I believed QE3 was on the anvil. On Thursday, September 13, the US Fed introduced QE3, its third quantitative easing programme.
The Fed’s actions last week have been widely seen as a fundamental shift in its monetary policy, and its communications with the public. Until now, the standard mantra among the major central banks has emphasised an inflation target of around 2%, and policy has usually been set with that primary objective in mind. Unemployment, meanwhile, has been left to adjust automatically towards its “structural” rate over a horizon of several years. Ben Bernanke indicated last week that he is no longer satisfied with this approach.
CNBC’s Larry Kudlow said he doesn’t advocate more stimulus—simply because he didn’t think it will have much impact, and would send the dollar into a tailspin. Former Federal Reserve Governor, Frederick Mishkin counters that it has worked. He suggests that further stimulus may finally drive the economy out of its rut. He believes further stimulus has an impact by reducing interest rates and increasing spending. Besides, according to him, that’s the only crap game in town. At the recently-concluded Jackson Hole symposium, Mr Bernanke went out of his way to provide a robust defence of the Fed’s unconventional monetary policy. He did so using historical analyses, some preliminary model results and whatever academic work he could find for what is still “unfamiliar territory”. His willingness to use imperfect tools to pursue what have been largely elusive macroeconomic objectives is more than just a function of the “daunting economic challenges” facing the US. He believes that the domestic headwinds reflect more cyclical structural factors. He rightly worries that the longer they persist, the greater the threat that cyclical problems could become structural in nature. While signalling that both baseline analysis and risk scenarios justify greater policy activism, he stopped short of providing details on the individual measures he favours. Instead, he retained optionality on an open-ended list, also managing to frighten short-sellers who doubt his ability to deliver.
I believe it would be imperative for the Fed to pre-commit to keeping the Fed funds rate close to zero until the 15.6% GDP gap had been closed (see Graph 1). Note that this would mean that zero short rates would persist even if inflation rose well above the Fed’s 2% target as the gap was closed. This commitment to keep short rates well below the levels which would be indicated by a “normal” policy rule like the Taylor Rule after the economy starts to recover is the crucial point. This commitment would, it is hoped, raise expectations of future nominal GDP, and thereby raise private sector expenditure on investment and consumption today.
Investors with long market positions cheered the Jackson Hole speech as well as the Fed decision on September 13. Indeed, every major market segment traded higher in price—from equities to government bonds and from corporate credit to commodities. It is tempting to attribute this broad price rally to the belief that all financial assets will benefit uniformly from repeated injections of Fed liquidity. But this is where investors should be more nuanced.
When Ben Bernanke launched QE2 in 2010, he outlined a third mandate for the Federal Reserve—boosting consumer confidence. He stated that the goal of QE2 was to boost asset prices in order to spur consumer confidence through the 'wealth effect', which should translate into economic growth. In 2010 he was right, and QE2 not only boosted asset prices sharply, but also kept the economy from slipping into a recessionary spat.
The Conference Board recently released a report on consumer confidence that was more than just disappointing. Not only did the consumer confidence index come in at the lowest level since 2011, when the government was last struggling with a debt crisis and US ratings downgrade, but the future expectations of the economy plunged a full 8 points from 78.4 in July to 70.5.
The problem for Bernanke today, it appears, is that the transmission mechanism between asset price increases and consumer confidence may be broken. When Bernanke has implemented balance sheet expansion programmes in the past, it has been done after asset prices had already taken meaningful hits--not when they are closing in on highs of the year. What Bernanke is potentially facing is that, while an additional QE programme might temporarily (and modestly) boost asset prices from current levels, it will not necessarily promote consumer confidence, which in turn leads to an economic lift.
Take a look at Graph 2, which compares the consumer confidence composite index with the S&P 500. You will notice that, historically, there is a fairly high correlation between asset prices and consumer confidence. You can see the bump to consumer confidence as asset prices have risen in the past.
Depending on the market segment, there can be significant and variable gaps between what Mr Bernanke is willing to do (a lot, and bolstered by the fact that the Fed is undershooting both components of its dual mandate), what he is able to do (more limited, since he is forced to resort to imperfect tools and without the support of other policy making entities), and ultimate effectiveness (even more limited given sluggish policy transmission mechanisms and insufficient global policy co-ordination).
Investors should not fight the Fed when it comes to what this institution, with its printing press, can deliver with a high degree of confidence—namely anchoring the front end of the US Treasury curve (up to the seven-year point as an illustration) and repressing related volatility. With renewed purchases of securities and its willingness to extend the guidance language into 2015, the Fed can keep these rates artificially low for quite a while.
Long-maturity US Treasuries are a trickier proposition for the Fed. This favours a number of assets, including high quality short- and intermediate-maturity corporate bonds, agency mortgages, related sales of volatility and even some high-quality non-agency mortgages and structured products. It also supports hard assets, such as gold, where people go in an attempt to protect against the potential risk of higher inflation.
The temptation to extrapolate this argument to other risk markets is tempting. But investors should recognise that the Fed has much less control on prices in the equity and high-yield segments. Similarly, a differentiated analysis is warranted for currency positioning.
Here, fundamentals—whether domestic or international—can overwhelm the impact of Fed action. This is especially true in today’s global economy; one that is in a synchronised slowdown, gripped by an unusual level of political polarisation in Europe and the US and lacking any sustained cross-border policy coordination. Technicals are also an issue. There are consequential differences among asset classes when it comes to the balance between traders and long-term investors.
In economic terminology, Ben Bernanke has indicated last week he is worried about two things: (1) hysteresis, where unemployment gradually shifts from the cyclical variety to the structural variety, and consequently becomes immune to Fed action; and (2) the decline in the labour force participation rate, which he thinks is proceeding faster than can be explained by demographic factors alone. He is concerned that the size of the productive and available labour force is “downsizing” to fit the diminished size of the economy, in which case the shrunken scale of both may become irreversible. He has said this before, for example in a speech in March, but never as powerfully as he did last week.
The author is CEO, Global Money Investor