It has been evident within the minutes of the US Federal Reserve Board’s open market committee that its members have been increasingly focused on the risks associated with the Fed’s unconventional monetary policy. The implosion in the gold price over the past week and the spreading volatility in other markets suggest those risks might have materialised earlier than the members anticipated.
The Fed’s purchases of $US85 billion of bonds and mortgages each month as part of its now long-standing quantitative easing program has kept US interest rates at negligible levels, as it intended. It has also forced investors into a pursuit of higher-returning and higher-risk assets, which was also intended as the Fed seeks to promote some growth in the US economy.
The program, however, may have been too successful.
The big risks of the QE programs were generally thought to be that they would eventually ignite inflation and that when they ended and US rates started to rise they could create bloodbaths in US bond and credit markets.
The risk of a meltdown in the bond market remains, with the Fed members increasingly discussing whether or not to end the program sometime this year. Concerns about inflation, however, appear to have receded, partly because of the stressed fiscal position of the US government and the dampening effects that has had and will continue to have on levels of US growth.
Both the members and the Fed staff have noted the potential for such a lengthy period of low long-term interest rates to encourage excessive risk-taking, which could have adverse consequences for financial stability by creating financial imbalances within particular financial markets.
There is little doubt that the major factor in the surge in global equity markets over the past six months has been fuelled by that search for higher returns. It is probably also not a coincidence that the gold price peaked around the same time that the equity markets took off, with investors less concerned about inflation than they were about returns.
What’s particularly interesting about the precipitous fall in the gold price over the past week is that it started on Tuesday last week – the same day that the minutes of the Fed’s March meeting were inadvertently released. (The Fed accidentally emailed the minutes to more than 150 people, including some of the world’s largest banks, a day early).
Whether it was the lack of concern about the prospects for inflation, the musings about ceasing the QE purchases before the end of this year or the worries about the unintended consequences within markets that unsettled investors is unclear but something in those minutes appears to have spooked markets already uneasy because of the fresh instability in Europe and a weaker growth outlook for China.
Certainly, if the market believed the Fed’s asset purchases – which have kept interest rates low and funnelled flows of funds into other markers – were likely to end in the near term, it would act in anticipation rather than waiting for the announcement that the program would end.
Perhaps that’s what we are now seeing – the unwinding of positions that had little to do with economic fundamentals or risk assessments.
With Europe in recession and its structural issues unresolved, China’s growth rate lower than the markets expected, and its own structural issues to address, and the US economic recovery faltering again, the global economic fundamentals don’t appear to support the levels of optimism that, until the past week, the markets had been capitalising.