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US already looking at ways to slow growth

23 Feb 2013 THE AGE - MALCOLM MAIDEN



IT'S been an interesting start to the year, to put it mildly. The Pope resigned: didn't see that one coming. Julia Gillard announced the longest election campaign in Australia's history. Didn't see that one coming, either.

In the business world, Rio Tinto announced yet more gob-smacking write-downs and showed its chief executive the door, BHP Billiton sorted out its CEO succession with back-slapping all round - and on Wednesday US time, the Federal Reserve revealed that the cash-bloated US economy may be in for liposuction sooner than expected.

With the Fed, it's a growth issue, which makes a change. Reserve Bank governor Glenn Stevens told the House of Representatives standing committee on economics on Friday that the threat of an uncontrolled sovereign debt meltdown in Europe has receded since mid-2012, that China's economic slowdown had "come to end" (a big call but probably correct in the medium term at least), and that the United States economy now had as good a chance of delivering an upside surprise this year as a downside one.

Stevens also said that Europe still faced "immense challenges," and while he didn't single out Spain, it's arguably the Euro-crisis pivot now.

Spanish Prime Minister Mariano Rajoy announced this week that Spain's budget deficit has slipped below 7 per cent of gross domestic product in 2012, above a 6.3 per cent target set by European authorities but within reach of it.

The government had avoided a shipwreck, he said - but it has cut the deficit from 11.2 per cent of GDP in 2009 with spending cuts and tax increases that have helped push Spain's unemployment rate to 26 per cent, and 55 per cent for under 25s. With the economy still in reverse after a 1.8 per cent decline last year the question is whether social and political stability can be maintained.

It was Stevens' comment about the United States that helped explain why the Fed's statement put the cat among the pigeons and clipped 2 per cent off the value of an over-heated Australian sharemarket on Thursday, however.

There's evidence that the US economy is growing, in areas including housing and construction markets that are crucial for jobs growth. The minutes of the Fed's rate-setting meeting suggest that a sizeable bloc inside the Fed is asking if the time to control growth is approaching.

Before the minutes were published, the markets were making two assumptions on the back of statements in December last year by the Fed and its chairman Ben Bernanke that directly linked US monetary policy to jobs growth.

The first assumption was that the Fed would keep its key short-term lending rates at an effective rate of 0 per cent at least until unemployment fell to about 6.5 per cent, with the caveat that inflation also needed to be held between 1 per cent and 2 per cent.

The second assumption was that a second layer of quantitative easing (QE) Fed stimulus totalling $US85 billion ($82.4 billion) a month as the Fed pays financial institutions cash for US government bonds and top-tier mortgage-backed securities in roughly equal measures would continue until the jobs market "improves substantially," to use the Fed's words in December.

Both accelerants will be withdrawn as economic growth accelerates in America if an outbreak of inflation that would undermine the recovery is to be avoided, and it is the quantitative easing overlay that will be withdrawn first. It's a huge task. The QE program has added about $US2 trillion or $2000 billion to the Fed's balance sheet.

The Fed's earlier statement that QE would continue until there was a "substantial" improvement in the job market was taken to mean that the Fed would move into reverse gear when the unemployment rate hit about 7 per cent, and until this week, most people thought that would occur next year. Then, if the jobless rate fell further to 6.5 per cent, rate rises would then kick in.

Whenever they happen, both steps will work to slow economic growth, and increase fixed interest rates and yields. They are economic hand brakes - applied to head off an unsustainable inflationary spiral that would kill longer term economic expansion, but hand brakes nevertheless, and the prices of both shares and existing fixed interest paper will be pressured as the process occurs.

Now, here's a summary of the crucial paragraphs of the minutes of the Federal Open Market rate-setting committee that were released this week.

The committee discussed quantitative easing. "Most" of its members said QE had eased financial conditions and helped stimulate economic activity, including housing demand and consumer demand. QE was also considered to have helped boost employment and reduce the risk of deflation, but (and here's what the markets latched on to) "many" of the committee's members also expressed "some concerns" about potential costs and risks arising from further asset purchases.

"Several" of them discussed how additional QE made the eventual withdrawal of QE more complicated, "a few" mentioned the prospect of inflationary risks, and "some" noted that further asset purchases could encourage unhealthy risk-taking in the markets. "Several" also observed the Fed could run up "significant" losses as it sold of its QE portfolio, and "others" argued that losses if sustained would not hobble the Fed. The minutes record that at the end of that lively discussion, the Fed's staff were told to go away and analyse the issues raised.

It's the contrast between the statement the Fed issued at the end of January confirming continuing QE and zero rates by a majority of 11 to 1 and the description in the minutes of many committee members expressing concern about QE that has unsettled the markets.

Are the "many" that are concerned about QE concerned enough to halt the program now? Almost certainly not. Are they in the majority? Unclear. Are they concerned enough to have their concerns recorded? Yes, obviously.

Does all this mean that the withdrawal of QE might begin in say, the third quarter of this year instead of the first half of next year as most expected? It would depend of course on economic growth continuing, and the jobless rate falling further, but it could mean that, and if so would be flagged from about midyear onwards: perhaps it already has been.

mmaiden@fairfaxmedia.com.au