A foretaste of QE's final triumph

The US recovery is clear for all to see as Fed calls for tapering grow. If markets can adapt, the central bank may even wind back its current bond holdings.

The US economy is slowly but surely getting to the point where the recovery is robust enough that the super stimulatory monetary policy currently in place can soon be wound back.

In yet another sign of increasing optimism about the sustainability of the US economic recovery, various officials in the Federal Reserve, including chairman Ben Bernanke, have been signaling that the aggressive and highly effective bout of quantitative easing is about to be phased down.

Overnight Richard Fisher, president of the Dallas Federal Reserve, joined the chorus saying that “we should dial back on the stimulus” and that “investors should not overreact to the central bank’s plans to slow bond purchases.”

While the exact nature of this tapering off of the bond purchasing program withdrawal of stimulus is yet to be fully canvassed, the increasingly broad and substantive pick-up in economic activity that will allow for the slow move to more normal monetary policy settings in the US is there for all to see.

The pace of job creation in the US remains robust, with an average increase of just under 200,000 jobs per month. The unemployment rate, which was 10 per cent at the depths of the recession, is now around 7.5 per cent and is ticking lower every few months. It seems likely that unemployment will be below 7 per cent early in 2014.

The housing sector is now in a fully-fledged recovery. House prices, new home sales, construction and home builder confidence are all strong. Admittedly this is from a low base, indeed a near depression level of activity, but the lift is spurring job creation and is supporting consumer confidence and rebuilding what was previously shattered wealth.

For the US banks, many of whom were being crushed under the weight of bad debts, a housing portfolio riddled with losses and depressed credit demand, high and rising house prices are something of a fix for these problems. Indeed, as house prices edge back towards their pre-crash levels, the banks’ bad debts diminish and in a self-fulfilling cycle of recovery, they are able to increase their lending 

Other positive signs in the US economy show up in retail spending, household consumption more broadly and business investment. The only major drag on the recovery is, curiously, public sector demand which is being held back by the fiscal tightening in place under the Obama administration.

Altogether, it appears that the US economy is on track in late 2013 or early 2014 to register 3 per cent GDP growth for the first time since the housing and banking crisis hit in 2007.

The recovery is showing up in the bond market, where yields are starting to be priced for an economic lift and heightened risks of inflation.

The US 10-year bond yield has, for example, risen from a recent low under 1.40 per cent in July 2012 and even 1.65 per cent in May to this morning’s yield of around 2.56 per cent.

This bond sell-off is big news.

Interest rates only rise in the US when there is investor confidence that the economy is moving to a growth phase that risks inflation pressures rising. This is starting to happen now and is exactly what Bernanke and the Fed were hoping to see.

To be sure, the Fed will not want to see yields rise too quickly as this would risk choking off the growth pick-up. But if markets and the real economy can show their ability to adapt to a slightly high yield environment, the Fed can and will start the massive job of not only scaling back the bond buying program but in time, it might even start to wind back its current bond holdings.

An increase in the Fed Funds rate, from levels near zero, is some years away and probably not worth consideration until the upcoming phase of bond purchasing stimulus is successfully unwound.

The long path to move monetary policy to a more normal setting will be rocky. Higher bond yields will erode some of the confidence that has been seen in stock markets as higher yields can make government bonds more attractive to investors.

US stocks have fallen around 5 per cent since Bernanke has directly addressed the notion of the Fed tapering off its bond buying program, with another 1 per cent lost this morning. At this stage such moves are not a major concern, but rather the markets starting to adapt to the notion that we could be seeing the start of a period of higher yields, strong economic growth and an eventual lift in inflation.

It is good news and exactly what the Fed was trying to achieve when it embarked on its unconventional monetary policy settings some four years ago.

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