Risks of QE are in the descent; Too slow a removal of stimulus could generate risky asset bubbles

December 20, 2013 8:32 am

Do not get wrongfooted on descent from QE

John Authers

Too slow a removal of stimulus could generate risky asset bubbles

The expected Christmas rally in the stock market finally arrived this week. US stock markets hit yet another all-time high, after sagging for several weeks.The genial white-bearded figure to thank for this was not Father Christmas, but Ben Bernanke. The chairman of the Federal Reserve, soon to step down after eight tumultuous years in charge of the US central bank, administered one last surprise this week, going through with the dreaded “taper” of the Fed’s QE bond purchases. Instead of spending $85bn on bonds each month to prop up asset prices, the Fed will now only be buying $75bn.

This is a big deal. The choices now confronting the Fed are like a climber’s at the peak of a mountain. Most deaths and accidents happen on the way down. On the way up, adrenalin is flowing, they are fresh and stepping upwards. On the descent, the adrenalin rush is over, they are tired and their feet are stepping down into the void.

Similarly, the risks of QE, a desperate measure to avert deflation and keep the economy ticking over, are in the descent, and not the ascent. When the policy was launched, the great fear was that it would spark inflation. This has not happened, at least to consumer prices.

But this is a narrow ledge. On the descent, there are risks associated with climbing down too fast or too slow.

Reducing support too fast would raise the risk of a panic by bond investors, once the Fed ceases to be the buyer of last resort. The yields on Treasury bonds, still regarded as the world’s safest asset, set interest rates for transactions throughout the world, so this had the potential for disaster.

Moving too fast would also raise the risk of capital flight. While US interest rates have been at zero, money has flowed indiscriminately out of the US to anywhere that offers a higher yield. Once that flow reverses, the danger is that the countries that needed this “hot money” would be exposed.

When Mr Bernanke first floated the idea of a taper in May this year, the mere prospect of such a thing made these nightmarish scenarios look more likely. Bond yields rose sharply, while money fled from big emerging markets such as India, Indonesia and Brazil. It also halted, for several months, the year-long rally in stocks.

This week’s move had far less impact. Emerging market currencies weakened on the news, but mostly held above their lows for the year, set when there was fear of capital flight. Treasury bonds sold off a bit, but 10-year yields, just over 2.9 per cent, remained below the 3 per cent they touched in September, when everyone was braced for an imminent taper. For these markets, Mr Bernanke looks like Santa Claus. He had, by the end of the year, performed a classic central bankers’ trick: gently removing the stimulus, and getting them ready for harder times, without triggering a panic.

More video

But in the Fed’s descent from its peak, there is also a risk of going too slow. If easy money stays for too long, then there is a risk of asset price bubbles, particularly in stocks.

The taper was small, but it came with remarkably generous guidance for the future. US unemployment is now at 7 per cent. The Fed does not expect it to hit 6.5 per cent until the end of next year. It also says the target Fed Funds rate will not rise from the current rate of zero until “well past” that time.

Six years ago, pre-crisis, this would have seemed unimaginably generous. Such low rates support corporate profits (by reducing their interest expense), and justify paying a higher multiple of those profits for the shares, because alternative fixed interest investments have such a low yield. Christmas came early for the stock market.

The risks now, then, are skewed towards a descent that is too slow, and a speculative bubble.

This should not obscure the success of Mr Bernanke’s strategy last year at the Fed. Having taken the daring decision to launch QE in the first place, it now looks as though he has engineered an economic recovery without sparking inflation, which now stands at 1.2 per cent. Five years ago when QE started, it was 1.1 per cent.

He has started to withdraw from QE, an expensive policy for the Fed, without accident so far. But as the descent goes on, the risk of a bubble in equity prices has risen. It grows ever harder to be out of the stock market, even though stocks have gained 40 per cent in 18 months, with little help from anaemic corporate earnings.

There is another risk. Inflation is now near the Fed’s lower band of 1 per cent. Commodity prices continue to fall.

QE’s purpose is to combat deflation. It may not have done its job. If US economic growth falters again, deflation risks will reappear. That would mean the Fed, with Janet Yellen in the chair, might have to embark on a fresh ascent, and add to its stimulus rather than tapering it off.

In that scenario, the only certainty would be greater volatility. But, for now, Ben Bernanke can take his leave as a jovial bearded figure distributing gifts.