How will the Fed's big gamble end?
There is not a person on the globe who knows how the US Federal Reserve will eventually reverse its pioneering monetary policy that has been in place for the past four years. This is unnerving because it remains the single most important factor in determining the medium-term health of the world economy and the immediate direction of global sharemarkets.
When Fed chairman Ben Bernanke took the bold step back in 2008 of cutting short-term lending rates to zero, many learned people said it would have unintended consequences, namely igniting inflation. Bernanke ignored them. In fact he became flagrant and took monetary policy to a whole new historical level by discovering a way to print US dollars called quantitative easing in a bid to kick-start the economy after the global financial crisis. His critics went into overdrive claiming his actions would result in rampant inflation and a collapse in the currency, as had been the case in the German Weimar Republic in the 1920s.
Four years on and inflation remains under control and the US dollar, while weak, has not collapsed. Maybe it is too early to gauge the impact of quantitative easing but unless inflation appears in the next two years, economic textbooks may have to be rewritten. Virtually every economics school in the world has preached the dogma that money printing results in unhealthy levels of inflation because more money chasing the same amount of goods simply drives prices higher.
In reality, though, Bernanke's extreme activity is only partially complete and he is acutely aware that he will have to reverse his textbook changing activity at some stage. He knows that with negative real interest rates (below the current level of inflation) and money being printed at a rate of $US1 trillion a year that unacceptable inflation levels will appear eventually.
So can the chairman pull the reversal off without unintended consequences?
In simple terms, three critical steps have to be taken to unwind the ultra loose monetary policy currently in place.
The first is bringing quantitative easing to an end. In the past four years the Fed has purchased about $US3 trillion in government back assets, effectively funding the US government's deficits. The former buyers of US government debt - China, Japan and the Middle East - have backed off resulting in the Fed being forced to do the heavy lifting. This means the Fed is on the money printing treadmill until the US economy clicks into gear. In other words he can't just stop purchasing assets when he feels like it, otherwise US bond yields will soar, as foreign buyers demand a higher return to buy them.
The second move for the Fed is to work out what it does with the $US3 trillion and rising assets it has purchased so far. Until recently the view has been the Fed will need to disgorge these assets, primarily government bonds, by selling them back to the market. This would flood the private market with debt, resulting in bond prices slumping and interest rates skyrocketing. A highly unacceptable situation for the economy and the sharemarket. Jumping bond yields have historically been a catalyst for falling equity prices.
In a recent speech Bernanke said the Fed might not eject these assets but simply roll them over as they mature. In other words, extend their life allowing the US government more time to pay them back. This approach has not been thought of before and may prove that the money printing can be taken off the table without unintended consequences.
The third and final step in the policy reversal will be lifting interest rates back to acceptable levels before inflation or brazen lending practices such as we saw in 2005 to 2007 emerge.
What should interest rates be? Typically if inflation is running at around 2 per cent, short-term interest rates should be slightly higher while the 10-year bond should be about double that level. This would mean the Fed has to lift the overnight lending rate from zero to around 3 per cent while the 10-year bond yield has to increase from 2 per cent to 4 per cent.
Bernanke would like to orchestrate all three steps at his own pace, but if the recent increase in US bond yields accelerates due to a pick-up in economic growth, he may have his hand forced. Alternatively, if the bears are correct and inflation hurdles above the Fed's 2 per cent target level, then Bernanke's grand plan might start to unravel.
To lose control of the process could be an unmitigated disaster. Global sharemarkets have ground higher over the past four years in the comfort that interest rates are low and will remain that way for many years to come. With the US market trading at approximately 15 times forecast earnings, investors are confident but have not been carried away with the liquidity swirling around. If the Fed's fire hose of money dries up and interest rates kick, then the sharemarket could easily drop 20 per cent to 12 times earnings. And that is why it remains incredible that no one has a clear answer on how this will play out.