THE SHOCK DECISION by the Federal Reserve not to start tapering in September squeezed bear speculators that were shorting US bonds, and generated positive reactions. Yields fell, while share prices rose and the dollar fell, as risk appetite returned.
In spite of the government shutdown and ominous threats of US debt default, most gains were preserved. But the Fed failed to regain control. Yields on treasury bonds are still more than 100 basis points above their May lows, and are much higher than where the Fed would like to see them. The markets welcomed the nomination of the ultra-dovish Janet Yellen as next Fed chairman. But she will face huge problems. Tapering cannot be delayed indefinitely, and reconciling conflicting views among Fed officials will test all her diplomatic skills.
Fears over political paralysis in Washington were key factors in the Fed’s decision, but there were also wider concerns. Most Fed officials thought it is right to begin tapering this year, and end asset purchases by mid-2014. But the damaging surge in bond yields since May persuaded a majority to wait, and not risk additional tightening now. Superficially, the government shutdown appears to justify the delay. But postponing the taper may prove to be a costly error.
The gridlock between Congress and the president reflects a deep-seated political malaise and, unless addressed, could damage the country’s long-term global standing. But quantitative easing is only a palliative. By bailing out the politicians from the consequences of their folly, the Fed may fail to do its own job properly. With the markets prepared for the taper to start in September, the operation would have gone smoothly. Setting a new date now would prove more difficult and disruptive. Given the markets’ addiction to cheap money, new excuses will be used repeatedly to force the Fed to postpone the taper. But the longer the Fed waits, the bigger the risks, and the greater the potential long-term harm to the economy.
US economic statistics are not being produced during the shutdown and policy makers as well as markets have to operate “in the dark”. It is not clear that the lack of official figures is causing genuine damage. We may be better off without the flood of economic figures that are frequently revised. Whatever the truth, the temporary absence of statistics provides an additional reason for caution.
Tapering will not start before December at the earliest. If the stalemate is prolonged, there will be no move until well into 2014. The reaction to events in Washington has been benign, as the markets signal their belief that the impasse will not cause damage, and cheap money will be available for longer than expected. But the risk of deterioration cannot be shrugged off. Official figures published before the shutdown show annualised third-quarter GDP growth of 2.5%, and an August unemployment rate of 7.3%.
The housing market is the main recovery driver. US house prices rose 12.4% over the 12 months to July, the biggest annual increase since February 2006. But the pace of monthly rises is slowing and mortgage applications are falling, as rising interest rates put pressure on home sales. The rate on a 30-year home loan rose from 3.81% in May to 4.23%, in spite of the decision to delay tapering. Overall, US performance compares favourably with the eurozone, but the Fed sees the economy as unduly soft. With US annual inflation at less than 2%, policy tightening will not be considered in the foreseeable future.
All the major central banks have pursued quantitative programmes since 2008, but there are important differences in scale and design. With the launch of “Abenomics” this year, Japan’s QE has been more aggressive than in any other major economy – about twice as large as US QE as a percentage of its GDP. Initial signs show it is effective. Japanese annual consumer price inflation rose to 0.9% year in August, the highest rate since November 2008. Previously, the US plan was the most expansionary, with open-ended monthly purchases of Treasury and mortgage bonds totalling $85bn (£53bn). QE helped to revive the US housing market, but other benefits are more doubtful. If Yellen’s nomination is confirmed, the Fed will remain strongly supportive of QE. But risks of future bubbles are gradually rising, and starting to taper in the next few months will remain a tricky priority. However, tapering will only mean less accommodation, not tightening.
The US, Japan and the UK are conducting their QE programmes by purchasing assets, mainly bonds, with the aim of increasing the money supply. In contrast, the ECB mainly operates through LTRO (long-term refinancing operation), a vehicle for giving commercial banks large amounts of cheap liquidity. While the ECB does not buy bonds, there is a scheme that enables it to do so, but only if countries apply and under strict conditions. So far there have been no takers, due to concerns that receiving help could be seen as a bailout. Repaying the €1tn provided under LTRO in 2011 is more than a year away, but recent rises in inter-bank rates signal tensions, and may force the ECB to inject new money through LTRO.
Risks of a major crisis have receded, but the eurozone economy is very fragile. The 12% unemployment rate is only marginally below its all-time high. Many European banks are weak and undercapitalised. Awkward issues, which have not been dealt with because of the German election, now require attention. In spite of Angela Merkel’s victory, forming a stable coalition will take time and this will make it more difficult for Germany to provide leadership.
The UK, after a long period of stagnation, is now enjoying the unusual status of star performer in Europe. After growth of 0.7% in the second quarter, stronger than expected, the third quarter could be even better. Most forecasters, including the IMF, now predict that UK GDP growth will be higher in 2013 and 2014 than in the eurozone as a whole, and higher than in Germany, the strongest European economy. This UK optimism may be temporary only, but it will remove any pressure for more QE for now. Forward guidance will be the main policy tool.
Download our Whitepapers
David Kern of Kern Consulting is Chief Economist at the British Chambers of Commerce. He was formerly NatWest group chief economist