All eyes are on how far Bernanke pulls back the QE lever
One of the fears about what the US Federal Reserve is about to do with monetary policy was raised before local trade on Friday by Bill Gross, the co-founder of Pacific Investment Management Company, the world's biggest bond investment retail fund.
The markets were still diving as he told Bloomberg that the Fed's timetable for retracting its $US85 billion ($92 billion) a month quantitative easing cash-splash was based on a Panglossian view of where the American economy was headed.
"The real economy won't follow the path the Fed thinks it will," Gross predicted, restating a view that led PIMCO to buy US government bonds before the Fed's signals that quantitative easing could be backed out.
Fed chairman Ben Bernanke had suggested that the US economy was headed to a gross domestic product growth run-rate of 3 per cent a year, he said, but "we have our doubts at PIMCO ... we simply think the real economy won't follow the path that the Fed thinks it will because the Fed is based on a cyclical model that's inappropriate".
Bargain-hunters pushed this sharemarket well off its early morning lows on Friday, which was unsurprising given the value that was emerging. Dividend yields on the big banks were approaching 6 per cent, for example.
For the bears, however, a key question is whether Gross or Bernanke is right.
On the basis of the US economic recovery it saw occurring, the Fed could begin trimming the size of quantitative easing stimulus later this year, Bernanke said on Thursday. He resisted attempts to pin him down further at his press conference, but after this week's events the percentage of US market economists surveyed by Bloomberg who think the retreat will begin with the Fed's mid-September meeting has risen from 27 per cent to 44 per cent, with $US20 billion favoured as the initial bite.
QE is, however, not being treated by the Fed in the same way as its policy of maintaining an effective zero per cent cash rate window for the US financial system. A rate rise is contingent on a sustained reduction in unemployment to 6.5 per cent, from a peak of 10 per cent in October 2009 and 7.6 per cent or so at present. Bernanke says the 6.5 per cent jobless rate is a threshold rather than an automatic trigger, but it gives solidity to the zero rate policy that QE policy does not have, and confidence that rates are on hold until 2015.
QE is tied more loosely to the Fed's overall reading of economic conditions. It's a more subjective process, and partly for that reason Bernanke went to considerable lengths in his press conference on Thursday local time to stress that the Fed was not locked into a QE retraction timetable.
A retreat could begin later this year and end by mid next year if the economy motored along as the Fed expected, he said. However, it could be withdrawn more slowly if the economy fell behind the Fed's forecasts, and could even expand beyond $US85 billion if the economy tanked.
The concern highlighted by Gross' comments is that if the flexibility Bernanke says the Fed has is based on a chronically over-optimistic read on the US economy, growth will dematerialise as debt yields and borrowing costs rise, and the Fed will still not react.
We don't know whether he is right or the Fed is right at the moment. What we do know, however, is that we won't die wondering. Data on the US economy is voluminous and dependable enough to decide the matter in fairly short order.
Gross says in particular that Bernanke is underestimating the effect of a tighter monetary policy on the housing market, which sparked the financial crisis, and is the engine of America's recovery.
As he points out and as this correction has demonstrated, it doesn't take an actual tightening by the Fed to squeeze borrowers. The Fed's heavy hints in April and May that the time to begin reducing QE was approaching and its announcement of a timetable this week have already generated bond selling that has pushed the yield on 10-year US government bond yields up from 1.6 per cent at the beginning of May to 2.35 per cent (handing PIMCO investors losses in the process). The yield on Fannie Mae mortgage bonds that are the pricing benchmark for home lending has risen from 3.35 per cent to almost 4 per cent in the same period.
Bernanke said in his press conference that the mortgage rate rise was not "dramatic", because confidence in the market was returning. Prices in 20 US cities rose 10.9 per cent in the year to March, the biggest rise in seven years; sales of existing houses were at their highest level in 3½ years in May and the stock of unsold houses is 10 per cent lower than it was a year ago. Sales of new houses are the highest they have been since mid 2008 when the financial crisis was peaking, and housing starts ran at 914,000 a year in May, far below the peak of more than 2 million starts a year before the financial crisis, but twice as many as the crisis low of 478,000.
Gross believes that borrowing costs have already risen enough to bear down on the housing market. Bernanke's lack of concern "is not reflective of what may lie ahead in terms of housing prices and the real economy", he says.
We will see. Remember, however, that even if Gross is right and the housing market cannot sustain higher borrowing costs, Bernanke is promising to modify QE if the US economy's performance disappoints. Gross's fears will only be confirmed if the downturn he predicts occurs and the Fed ignores the evidence.