BEN BERNANKE’S confirmation that the Federal Reserve will start tapering its $85bn (£56bn) monthly asset purchases this autumn, with the programme likely to end around mid-2014, has plunged the markets into turmoil.
The fall in bond prices, and the resultant increase in yields, gathered momentum after the Fed confirmed its plan to start reducing the stimulus. But, since the central bank is by far the dominant financial player, the impact was global. Bond funds experienced huge outflows, as investors reacted to mounting losses. Many emerging markets faced disorderly capital outflows and sharp currency falls. For the European Central Bank and the Bank of England, rising bond yields are unwelcome, and they are now trying to cope with the consequences. But, in spite of the turmoil unleashed by the Fed, global optimism persists and equity markets remain strong.
The bond markets’ reaction has unnerved the Fed. One senior official used the unflattering term “feral hogs”, to describe the traders’ irrational behaviour. After all, tapering would only start if the US economy continues to improve. Asset purchases would only end next summer if the unemployment rate falls to 7%. Policy will remain very expansionary, even after the programme ends. Fed rates are set to stay virtually at zero until there is a further fall in the US jobless rate to 6.5%, and this is unlikely to happen until 2015.
But, in spite of these provisos, the Fed’s move is a defining event. It has always been clear that massive injections of liquidity in recent years by the world’s central banks cannot be cost-free, whatever the benefits they may produce. Exiting the huge stimulus, or even scaling it down, may cause big disruptions. If the skirmishes between the Fed and the markets escalate, there could be collateral damage. It remains to be seen if the equity markets’ optimism is justified.
As bond yields in the US and Europe rose to more normal levels, and the dollar strengthened, earlier big inflows into the emerging markets were partly reversed. Gold and commodity prices other than oil fell, as the dollar regained its haven status. Political instability reinforced these pressures. The civil war in Syria and the unrest in Egypt put new pressure on oil prices, while large protest demonstrations in Turkey and Brazil reinforced the flight from emerging market assets and currencies.
In China, the government tightened credit conditions, in order to limit the risk of bubbles; but this created a dangerous crunch, as short-term money market rates rose to record highs. To avert the threat of chaos, the Chinese authorities relented and agreed to supply more liquidity than they originally intended. But the basic dilemmas remain unresolved. China’s growth must be slowed to a sustainable pace of 6-7%, and the overblown pace of credit expansion must be reduced. The critical question is whether this can be achieved without a painful hard landing and a nasty overhang of bad debts.
The US economy is making uneven progress. GDP annualised growth in the first quarter of 2013 was a disappointing 1.8%, a sharp downward revision from the earlier estimate of 2.4%. But the recovery in housing is gathering momentum. Home prices rose by 12.2% year-on-year in May, the largest annual increase since 2006. The jobs market is strengthening, helping to sustain consumer confidence. The US created 195,000 new net jobs in June, well above expectations; revisions to April and May data added a further 70,000 jobs to previous estimates.
But the unemployment rate stayed unchanged, at 7.6%, as more people returned to the labour market in the hope of finding work. Jobs growth averaged just over 200,000 per month in the first half of 2013, justifying Ben Bernanke’s decision to start tapering the stimulus. But with the jobless rate still over 7.5%, and with GDP growth remaining mediocre, US policy will remain expansionary for at least another two years. If the markets accept that tapering does not mean tightening, the turmoil will subside.
The ECB is usually more conservative than the Fed. But, since yields on European bond rose in sympathy with those on US Treasuries following Bernanke’s decision to taper, the ECB was forced to abandon its traditional reluctance to pre-commit to a course of action.
Unlike the US, the eurozone is still mired in recession, with negative GDP growth in the first quarter, and with a high 12.1% unemployment rate. Although there are tentative signs that the decline in activity is easing, eurozone GDP is forecast to fall by 0.6% in 2013 as a whole. In the face of threats facing the banking sector, and with renewed tensions relating to Portugal, ECB president Mario Draghi announced explicitly that he expects the key ECB interest rates “to remain at present or lower levels for an extended period of time”. This pre-commitment is clearly a major change in the ECB’s communication strategy.
In the UK, the arrival of Mark Carney as new Bank of England governor coincided with signs that the economy is gradually recovering. Positive business surveys and rising confidence have fuelled expectations that GDP growth in the second quarter would be higher than the first quarter rise of 0.3%.
But the UK recovery is not secure, and many risks persist. Global turmoil as the US Fed reduces its stimulus, and problems in the eurozone, could have adverse effects on the UK. The rise in inflation in May to 2.7%, unless rapidly reversed, risks worsening the squeeze on businesses and consumers. In this uncertain background, the economy needs stability. At its first meeting under Mark Carney in July the MPC decided to keep policy unchanged, with Bank Rate at 0.5% and the QE programme at £375bn. But the MPC stated that recent changes in expectations, signalling that interest rate rises could occur earlier than previously envisaged, are “not warranted”. This was the right decision. Given the risks of higher inflation, we do not need more QE. But it is very important for the MPC to make it clear that interest rates will stay a their current low level for a considerable period.
David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist