Bernanke's test finds the market wanting

The fact that Ben Bernanke's mention of a possible early end to QE temporarily whacked markets overnight suggests we won't see an end to the policy anytime soon.

If ever there was any doubt, we certainly found out how the markets will react if any of the super-stimulatory monetary policy settings in place in the US are withdrawn prematurely.

The US and global stock markets took fright yesterday at the mere consideration of a slowing in the pace of quantitative easing and there were savage falls in share prices that spilled over to Asia and Europe. With a realisation overnight that such a monetary policy reversal will only happen when the economy is stronger and on a sustainable footing, the US market stabilised and the fear was short-lived.

Perhaps US Federal Reserve chairman Ben Bernanke deliberately aimed to test the market reaction as he spoke of the possibility of scaling back the stimulus, even though it is obvious that he has absolutely no intention of doing so until the US economy is materially stronger.

The negative tone set by Bernanke and the US market sparked doubts about the Japanese stimulus experiment to the point where the Nikkei fell a thumping 7 per cent. While this fall is large, it should be viewed in the context of the rise of over 75 per cent in the prior 10 months.

The release of a disappointing Chinese manufacturers purchasing managers index, which fell to a seven-month low of 49.6 points, only served to sour the mood. There are increasing doubts as to whether China can grow at 8 per cent in 2013 and 2014 given the backwash it is feeling as the eurozone - China’s major export market - continues to flounder in recession.

The market reaction shows how fragile global economic conditions still are and just how dependent they are on policy remaining easy and stimulatory. In other words, those advocating an end to easy policy and flagging a possible move to less easy policy are wrong. Dreadfully and hopelessly wrong. 

The hangover from the global banking and financial crisis is still very real. Banks in the US, UK, Europe and Japan are not yet truly profitable, or at least are only keeping their heads above water on the back of historically low interest rates, which in turn are being driven by aggressive QE. Take QE away and they are dead ducks.

At the same time, private sector demand does not yet have the traction or momentum to sustain a job generating expansion while at the same time, fiscal policy contraction in the US and throughout much of Europe is slamming a foot on the brake of the economy while monetary policy is set for maximum acceleration.

Even though fiscal austerity is increasingly seen as the wrong policy for the current economic environment, despite the high level of government debt in many countries, any move to genuine and meaningful fiscal stimulus anywhere other than in Japan seems unlikely. Rather, the concession to fiscal austerity appears to be under consideration which will mean slowing the pace of fiscal adjustment, rather than reversing it.

The mood of the markets overnight was also calmed somewhat by some solid economic data in the US. The housing recovery maintained a solid upswing with new home sales rising to be at the second highest reading in five years, while the median selling price for houses rose 14.9 per cent over the past year. Home builder confidence also rose. The weekly reading on jobless claims also fell, suggesting that the very slow improvement in labour market conditions is set to continue.

There needs to be a lot more favourable economic news along these lines before the Fed can seriously consider ending its program of zero interest rates and QE. Maybe 2015 might be the time when that happens.

The very reaction of the markets in recent days will ensure that the monetary stimulus is not taken away too early. For those of us who like to see and favour economic growth, job creation and falling unemployment this will be good news. For the monetary policy hawks, it looks like being another year or two where their snake oil policy prescriptions are discredited and rightfully ignored by those pulling the policy levers.