Fed's delay a cause for confidence

The Australian dollar's US1.5¢ leap on Thursday showed how surprised traders were that the US Federal Reserve did not trim its $US85 billion-a-month quantitative easing (QE) program, and there are several theories about what happened.

One is that Fed chairman Ben Bernanke has become a "lame duck" as his retirement approaches. Another is that he has played the markets like a Stradivarius, creating a market rally out of nothing. A third, the most popular, is that the Fed underestimated the impact of its messages that the taper was coming, and now needs time to assess how much collateral damage it has caused.

The Fed reported that it had discussed the timing of a QE taper after its April 30-May 1 meeting. It elaborated in the minutes of the meeting on May 22, and a few days later Bernanke told Congress that the taper could begin in the next few months, if the US economy continued to improve.

On June 19 it met again and upgraded its US economic growth forecasts. Bernanke told a press conference that the taper could begin by year-end, and be completed by mid-2014.

He stressed that the timetable was pinned to America's economic progress, and job creation in particular. QE could shrink, remain the same or expand depending on how the economy developed, he said. Other Fed officials said similar things in the following days and weeks.

Bernanke's words were nevertheless interpreted as a harbinger of an imminent move. He had presided over unprecedented expansion of the Fed's balance sheet from less than $1 trillion to more than $US3.5 trillion with the QE program, but was now being recast as a monetary policy hawk.

Share prices fell, the price of gold plunged, and most importantly, US government bond yields rose, pulling mortgage lending rates up in the process. Ten-year US Treasury notes were 1.6 per cent at the start of May, up from 1.38 per cent in July last year. They were above 3 per cent ahead of this week's Fed meeting. A 30-year US mortgage was priced at 3.5 per cent in mid-May. It was above 4.5 per cent ahead of the meeting.

The lame duck theory is that the delay in the taper shows that Bernanke the born-again hawk has been sidelined by his doveish deputy, Janet Yellen. He finishes his second four-year term as Fed chairman at the end of January, and is not expected to want or get another. Yellen became favourite to replace him just before this week's Fed meeting, after Lawrence Summers ruled himself out of contention.

She has been a key supporter of QE, and the possibility that the decision not to begin the taper this month reflects her growing power inside the Fed was floated on Thursday by Bill Gross, the co-founder of the world's biggest bond fund, Pimco.

The Stradivarius theory assumes that Bernanke is still a dominant influence - he has also been a supporter of QE, of course - and argues that like treasurers and finance ministers who threaten a "horror budget" and then deliver something less severe, he has engineered what the markets call a "positive surprise".

Bernanke's message that QE is coming is still in the markets. He said again on Thursday that it could begin before Christmas. And while the 10-year US government bond yield fell to 2.68 per cent after the taper failed to arrive, it was still more than one percentage point higher than it was before talk of a taper began.

Through inaction, Bernanke has meanwhile demonstrated that the Fed can be flexible, so the theory goes. US job market conditions were "still far from what all of us would like to see", he said after the meeting, and the Fed was concerned "that rapid tightening of financial conditions in recent months would have the effect of slowing growth".

The tightening of financial conditions he referred to is the rise in yields and mortgage rates, and theory three is that the mortgage rate rise in particular is causing concern, even though yields and rates are still only about half their pre-crisis levels.

The Fed's decision on Thursday to downgrade its forecasts for US economic growth for this year, next year and 2015 including a 0.3 point cut in this year's forecast to between 2 per cent and 2.3 per cent supports the theory, and Bernanke's comments do, too.

There's still more evidence, on balance, that the US economy is accelerating than there is evidence of it stalling, however. QE's retreat is still possible by year-end.

The Reserve Bank has a short-term problem on its hands until it does. The odds on a rate cut here to contain the $A's strength have shortened.

When QE does begin backing out the September pause should help, however. The lingering fear in the markets ahead of the meeting was that the QE retreat was on auto-pilot. After this decision, there should be more confidence that it will be carefully managed, and its impact on the economy closely monitored.

mmaiden@fairfaxmedia.com.au