Given repeated Fed policy shifts in recent months, it is useful to step back and review the changes and consider their significance in perspective in terms of future impact on the US and global economy. The following article suggests elasticities between financial asset prices and Fed QE policy are becoming more unstable -- i.e., more elastic -- while more inelastic between Fed policy and real investment. As the Fed continues its "stop-go" approach to reducing QE3 liquidity injections, markets are becoming increasingly sensitive to each attempt in terms of timing, rate of change, and magnitude of response to the Fed's shifting QE intentions. Fed forward guidance policy in turn is becoming less effective, and monetary policy instability is potentially rising. Is the Fed slowly losing control of monetary policy as a consequence of repeated "stop-go" intentions with regard to QE? What are the consequences for emerging market economic growth, financial asset price volatility, and the US economic recovery?
A week ago, the US central bank, the Federal Reserve (Fed), opted not to change its current 3rd Quantitative Easing (QE) policy providing $85 billion a month in bond purchases from bankers and investors. The Fed's QE3 policy has been in effect for about a year, injecting thus far approximately $1 trillion into the US and global economy. Since QEs began in 2009, at the current QE3 rate the total injection will have exceeded $4 trillion by the end of 2013.
Consensus was strong in early September 2013 that the Fed would at least slightly reduce that $85 billion by a token $5-$10 billion a month. That would have provided a mild, second signal it would begin reducing its $85 billion a month money injection.
Last May 2013, the Fed's chairman, Ben Bernanke, signaled for the first time to markets the Fed might soon start "reducing" QE. That set off what has been called the "taper tantrum" by investors. Almost immediately in response to the Fed's suggestion, rates on bonds began to escalate, including mortgage rates, corporate and US Treasury bonds -- all of which surged by more than a full 1% in a matter of weeks.
The outcome was that the tepid US housing market recovery almost stalled, stock and bond prices began to tank, and investment into "emerging markets" -- where much of the total $4 trillion in QEs since 2009 has gone -- began to reverse and flow back from abroad to the US and Europe. Emerging markets' currencies in turn began to decline, the global currency war ratcheted up another notch, and capital flight from those economies to the west accelerated.
Faced with the "taper tantrum," the Fed quickly shifted its policy signal in early July once again, reassuring investors that a significant retraction of QE3's $85 billion wasn't really their intention. Financial asset prices rose back again.
Then, as part of its "forward guidance" policy, the Fed in August, tried to extricate from its QE3 program a second time, this time more cautiously than it did in May, signaling it might reduce its monthly QE3 policy at its upcoming mid-September 2013 meeting.
Extrication from QE3 has become increasingly necessary. Fed policies are becoming increasingly "inefficient" -- that is, while feeding financial asset bubbles they are yielding decreasing increments in real investment in goods and services. As QE continues and financial asset market prices rise, a number of recent reports show the growth of gross private domestic investment long term continues to slow. According to one recent report on the UK economy, only 15% of financial flows since 2009 are now going into real investment in goods and services. Other analyses in the US reflect the same trend.
The Fed's second "forward guidance" in August of its prospect of tapering in September led in the case of emerging markets to renewed capital flight, currency declines, rising interest rates and slowing economic growth.
At the same time, by late summer in the US, a number of economic indicators began to show that the US economic recovery is not as strong as the press hype has been suggesting. Moreover, the Fed lowered its own forecast for the US economy, from 2.5% earlier in 2013 down, most recently, to 2% GDP growth. (That downward revised forecast was not the first. In fact, the Fed has consistently reduced its US economic forecasts for the past three years, from an originally predicted 4.3% annual GDP growth.)
Then on September 16, the Fed shook markets and investors by deciding not to "taper" at all for the moment, suspending its August guidance of a "token taper" of $5 or $10 billion a month.
A longer perspective on recent shifts in Fed policy since May reveal that, in a matter of just a few months, the Fed has shifted from responding to the "Taper Tantrum" to suggesting a "Token Taper" to a subsequent retreat once again. Two efforts at reducing QE that resulted in two quick retreats from the same.
Over the past week it appears a third "go" at reducing QE, as several Fed board governors are once again suggesting a third time that a reduction of the $85 billion will occur before year end, and perhaps even start in October.
The retreat from the "Token Taper" in recent weeks has given way to the emergence of an imminent "Taper Tomorrow."
What all this policy shifting signifies is that in the last several months the effectiveness of the Fed's "forward guidance" policy is deteriorating significantly. Fed policy is entering a period of a public crisis of confidence that could well lead to increasing stock price volatility, and at a time that increasingly acrimonious "debt ceiling" negotiations between Congress and the Obama administration are beginning to intensify and suggest even more volatility.
The response of financial markets -- in terms of response time, rate of change, and magnitude of price shifts -- to the Fed's double "stop-go" (and now "go" again) QE tapering plans illustrates the tight positive correlation between financial asset prices and QE that has been evident ever since QEs were first introduced four years ago. At the same time, evidence of correlation between QEs and real investment continues to decline.
What the Fed's "stop-go," on and off, QE policy signifies in a broader sense is threefold:
First, that investors have become addicted to the QE, low interest and free money policies of the Fed that have been in effect the past five years -- as this writer predicted would occur nearly two years ago elsewhere. The mere suggestion of a QE retraction, even when token, results in rapid and significant financial asset price declines and rising interest rates. A "cold-turkey" withdrawal of QE liquidity sends markets into tailspins that recover just as quickly when assurances of liquidity restoration occur. However, while asset prices return to prior levels, interest rates do not and instead drift upward.
Moreover, each time the Fed retreats on its signal to taper, it makes the next attempt even more difficult as investors anticipate and become even more predisposed to quickly respond to counter any Fed suggested move. The elasticity of asset price response increases-both in terms of timing, rate of change, and magnitude.
Secondly, the Fed's recent stop-go policies suggest the real economy has become super-sensitive to interest rate hikes-just as it has become "super-insensitive" to interest rate reductions over the past five years. In economists' parlance, this is expressed as the economy having become "increasingly inelastic" to interest rate declines -- i.e., falling rates generating little real growth -- while conversely becoming "increasingly elastic" -- rising rates quickly slowing real growth -- to interest rate hikes.
QE is thus resulting in the real economy responding less and less positively to money supply injections and interest rate declines, while more and more negatively to money supply reductions and interest rate hikes.
Thirdly, the Fed's key policy of "forward guidance" is unraveling as a consequence. No one really knows what the Fed is going to do now, how it plans to do it, and when and at what rate it plans to begin doing it. In short, as it engages in repeated "stop-go" QE reduction signals, the Fed is slowly losing control of the monetary tools by which it has been stabilizing the banking and financial system the past five years.
Emerging markets may react even more volatile to the next taper iteration by the Fed, producing even more currency volatility, capital flight, and economic slowdown. More hot money will flow into China's increasingly fragile local property markets via its growing "shadow" bank network there. Financial asset bubbles, having returned in the interim, will pose an even greater risk of too rapid asset price contraction at some later date.
In conclusion, this writer's prediction is that asset prices in the coming months will become even more (positively) "super-sensitive" to QE withdrawal efforts by the Fed, while the real economy becomes more (negatively) super-sensitive to interest rate hikes.