Fed ponders action on cashed-up economy

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

It's been an interesting start to the year, to put it mildly. Julia Gillard announced the longest election campaign in Australia's history: didn't see that one coming. The Pope resigned: 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, the US 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. The 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 the middle of last year, that China's economic slowdown had "come to end," (a big call but probably correct in the medium term at least) and the US had extended its gradual economic recovery, and 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.

The Spanish Prime Minister, Mariano Rajoy, announced this week that Spain's budget deficit slipped below 7 per cent of gross domestic product last year, above a 6.3 per cent target that was 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 gross domestic product in 2009 with spending cuts and tax increases that have helped push Spain's unemployment rate to a politically destabilising 26 per cent. A staggering 55 per cent of working-age Spaniards aged 24 or younger are out of work and with Spain's economy still in reverse after a 1.8 per cent decline last year, the question is whether social stability can be maintained.

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

There's evidence that the US economy is growing, and growing in areas including housing and construction markets that are crucial for jobs growth. This is good news. Let's get that established at the outset. The minutes of the Fed's rate-setting meeting suggest, however, that a sizeable bloc on the committee are asking if the time to control growth is approaching, and, perhaps, that the same bloc believes that the time to give warning has arrived.

Before the minutes were published, the markets were making two assumptions on the back of announcements by the Fed and comments by its chairman, Ben Bernanke, at the end of last year 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 zero per cent at least until unemployment fell to about 6.5 per cent, with the caveat that inflation also needed to 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 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.

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 QE overlay that will be withdrawn first. It's a huge task. The QE program has added about

$US2 trillion 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 probably 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 kick in.

Whenever they happen, both steps will work to slow economic growth, and increase fixed interest rates and yields. They are economic handbrakes - applied to head off an unsustainable inflationary spiral that would kill longer-term economic expansion, but handbrakes 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 Fed's open market rate-setting committee that were released this week, and may have changed the timeline for QE-Minus.

The minutes report that the committee discussed quantitative easing. "Most" of its members said QE had eased financial conditions and helping 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 that the Fed could run up "significant" losses as it sold 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.

The minutes also report that "several" members of the committee also argued for more flexibility in QE asset purchases, more if the signs are weak and less if the economics are stronger, and a few members expressed concern that heightened cost-benefit analysis of QE would see it curtailed before a substantial improvement in the jobs market was locked in.

It was the contrast between the statement the Fed issued at the end of last month, confirming continuing QE and zero rates by a majority of 11 to 1, and this week's report that "many" of the committee's members expressed concerns about the QE program that unsettled the markets.

Are the many who 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 get their concerns into the minutes? Yes, obviously.

Does all this mean mean 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, and if so would be signalled from about midyear onwards: perhaps it already has.

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