The US Federal Reserve is on the cusp of something big after nearly two years of propping up the American economy’s recovery with an aggressive fiscal stimulus policy. But Janet Yellen, the new Chair of the Fed, has ruled that enough is enough. The move was announced in July, but the tapering programme is only set to kick in around October, giving markets plenty of time to prepare and adjust to what will almost certainly be a jolt to the system.
When the announcement was made in July that the stimulus programme would be tapered off in October, the headlines the following day were very fatalistic: “Fed stimulus is really going to end and nobody cares”, in The Wall Street Journal, was particularly dramatic. But the fact of the matter is that it really should not be that big of a deal.
First, to suggest that the stimulus package would end outright in October is just not correct. What is actually happening is that the Fed will stop increasing the rate at which it provides stimulus. “For the mathematically inclined, it’s the first derivative of stimulus that is going to zero, not stimulus itself,” explains Donal Marron, the American financier and entrepreneur in Forbes. “For the analogy-inclined, it’s as though the Fed had announced (in more normal times) that it would stop cutting interest rates. New stimulus is ending, not the stimulus that’s already in place.” And it is an important distinction. At the moment, the Fed is committed to purchasing $35bn in bonds – much less than the $85bn of bonds it picked up at the height of its stimulus programme in January.
Whenever there is a hint that a central bank will resort to QE, the villagers pick up their torches and stakes and march through the towns
“If the economy progresses about as much as the Committee expects… this final reduction would occur following the October meeting,” read the minutes of the Federal Open Market Committee (FOMC). The documents also suggested that if all went according to plan, the bond-buying budget would be cut by $10bn before one final snip of $15bn in October. So, though there will be no new bond purchases, the Fed remains committed to the $4trn worth of treasury bonds and mortgage-backed securities it has hoarded over the years.
Taking the plunge
The Fed has been threatening to cut off its bond buying since at least last October, so it should not have come as any surprise that Yellen finally committed. The stimulus programme, which included lowering long-term interest rates as well as aggressive bond-buying, was never meant to be a long-term solution to the US’s lumbering economy; the Fed had no option but to cut it before the crutch became a full-on extra limb. However, because talk of tapering has been on the table since last year, investors have been uncertain about how to proceed. It was the right time to make a call.
And while some, like Marron, argue that it is the “stock of assets” owned by the Fed that matters, and that, therefore, while it continues to own the bonds and securities purchased over the past two years it will continue to stimulate the economy indirectly by forcing investors to look elsewhere for desirable assets. There are some who would disagree and maintain that the rate at which the Fed purchases these assets is what matters, especially when it comes to quantitative easing (QE).
The Fed’s QE policy has been heavily criticised over the past two years. Some would argue that by keeping interest rates so low for such an extended period of time, the policy has actually pushed investors towards more risky behaviour like investing in stock and corporate debt, fuelling rumours that a bubble might be driving the recovery.
Yellen, however, has steadfastly refused to pander to critics, and has defended both the stimulus programme and the decision to taper it. In a speech at the International Monetary Fund in July she admitted that there were indeed “pockets of increased risk-taking across the financial system”, though she insisted that “the policy approach to promoting financial stability has changed dramatically in the wake of the global financial crisis”, and that the Fed had “made considerable progress in implementing a macro prudential approach in the US, and these changes have also had a significant effect on our monetary policy discussions”.
Whenever there is a hint that a central bank will resort to QE, the villagers pick up their torches and stakes and march through the towns. But QE is not the monster it is often made out to be. Ben Bernanke, Yellen’s predecessor, had already lowered interest rates significantly through conventional means, and had been stuck between a rock and a hard place. He turned to QE for the third time since the onset of the global financial crisis, but with the added boost that this time, the stimulus programme would be carried out indefinitely, for as long as necessary.
Double-checking
The last question for Yellen and the Fed to answer is when will they start to raise interest rates again. That is a much deeper issue than the tapering off of QE. Mark Carney, Governor of the Bank of England, is facing similar issues as his side eases into recovery as well. It appears that the Fed may be getting ready to step it up a gear, though, as minutes of the FOMC July meeting revealed members are increasingly restless about raising rates. “Most participants indicated that any change in their expectations for the appropriate timing of the first increase in the federal funds rate would depend on further information on the trajectories of economic activity, the labour market, and inflation,” the minutes said. It is clear the Fed will take no more concrete steps before it can be reassured that the economy is faring well without being propped up by the stimulus programme.
The signs are encouraging at the moment. Unemployment in July was down to 6.2 percent, from 7.3 percent a year before and inflation is finally on the up after remaining stubbornly below the Fed’s target of two percent for the past two years. Overall, the US economy grew four percent in the second quarter after a brief slump in the beginning of the year. If this becomes a trend, Yellen may be compelled to raise interest rates sooner rather than later.
Economists will debate for many years if the recovery was at all down to the Fed’s stimulus package or if it would have occurred regardless of those measures. However, it is unquestionable that recovery is taking place. Furthermore, when Bernanke hinted at a possible tapering off of the stimulus programme last year, the market went into panic mode, and everything from stocks to foreign currencies took a momentary but steep stumble.
When Yellen made the final announcement in July and it was finally confirmed that the bond buying would come to an end, the market barely noticed. That is an encouraging sign; players feel strong enough to withstand the removal of the stimulus without fuss. It also proves that regardless of the stimulus programme’s merits or faults, economically it served as something of a placebo, reassuring the market on a deeper level.
