How will the Fed's big gamble end?
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 (QE) 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 QE 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 about 15 times forecast earnings, investors are confident but have not got 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. This is why it remains incredible that no one has a clear answer on how this will play out.
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Frequently Asked Questions about this Article…
Quantitative easing (QE) is the Fed's program of buying government-backed assets to inject money into the economy. According to the article, the Fed bought about US$3 trillion of assets over four years and was printing roughly US$1 trillion a year. For everyday investors, QE mattered because it kept interest rates very low, supported global sharemarkets and influenced bond yields, liquidity and asset prices.
Unwinding QE is risky because removing the Fed as a major buyer of government debt could push US bond yields higher and flood the market with supply. The article explains that selling or disgorging the US$3 trillion of bonds could make bond prices slump and interest rates spike — historically a catalyst for falling equity prices. Sudden tightening could force markets lower.
The article outlines three critical steps: 1) bring quantitative easing to an end by stopping asset purchases; 2) decide what to do with the roughly US$3 trillion of assets already bought (either sell them or roll them over as they mature); and 3) lift interest rates back to more normal levels before inflation or excessive lending re-emerges.
Instead of selling bonds back into the market, the Fed could choose to roll them over as they mature — essentially extending their life on its balance sheet. The article suggests this approach is less disruptive because it wouldn't flood the private market with new debt, potentially allowing the Fed to take money printing off the table without triggering a sharp rise in yields and crushing bond prices.
Using the article's example, if inflation is around 2%, short-term interest rates should be slightly higher and the 10-year bond yield about double inflation. That would imply an overnight Fed rate rising from zero to around 3% and the 10-year US bond yield moving from about 2% to roughly 4%.
The article highlights two main risks: 1) a pickup in economic growth that accelerates bond yields faster than planned, forcing the Fed's hand; and 2) higher-than-expected inflation above the Fed's 2% target, which could unravel the Fed's carefully staged reversal and lead to a more abrupt tightening of policy.
If the Fed stops providing massive liquidity and interest rates rise, the article warns global sharemarkets could fall sharply. It estimates the US market, trading at about 15 times forecast earnings, could drop around 20% back toward 12 times earnings if the Fed's liquidity dries up and rates rise — a scenario investors should be aware of given current valuations.
The clear takeaway is uncertainty: no one knows exactly how the Fed will unwind its pioneering policy without unintended consequences. The Fed faces a delicate balancing act — ending QE, managing its US$3 trillion balance sheet and raising rates to normal levels — and missteps could significantly affect inflation, bond yields and stock market returns.
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