Next week’s meeting of the US Federal Reserve Board’s Open Market Committee is shaping up as an important moment for global financial markets.
The Fed isn’t actually expected to do anything momentous at the meeting next Tuesday but the language of the statement the committee issues after its deliberations is going to be pored over for even the slightest indication that the beginning of the end of its quantitative easing program is drawing nearer.
There is, with hindsight, little doubt that it was testimony given by Ben Bernanke to the US Congress last month that sparked the enormous volatility in financial markets in the past three weeks.
In that testimony, on May 22, he said that if the Fed saw sustainable improvement in the US economy it might scale back its $US85 billion a month of bond and mortgage purchases "in the next few meetings" of the FOMC.
The comments triggered a steep sell-off in equity markets and gyrations in currency markets and a reversal of various carry trades that has, momentarily at least, undermined the desperate attempts by Japan to reflate its economy and, closer to home, punctured the value of the Australian dollar.
There is a growing sense that the Fed’s bond-buying has served its useful purpose and, indeed, that it is having little impact on the US economy, which has been growing modestly.
It has also been apparent from the FOMC minutes that there are a number of members of that committee who have become increasingly concerned about the unintended consequences of maintaining such a large-scale program and the potential for severe dislocations in markets when the Fed tries to wind back the program.
The markets’ response to even the hint that the Fed might start to "taper" the QE III program – global equity markets are down nearly 6 per cent since Bernanke’s testimony and the Nikkei is down 20 per cent while exchange rates have been fluctuating violently – underscores how delicate that moment might be.
It is unclear why Bernanke decided to flag an earlier-than-expected reduction in stimulus before Congress, although it could have been a sop to the hawks within and outside the FOMC. It may also have been an attempt to inject some uncertainty into markets to try to discipline behaviour.
The combination of the Fed’s program and a similar exercise in Japan, designed to drive down the yen to improve Japan’s competitiveness, opened up a number of apparently riskless carry trades that, as discussed yesterday (Abe’s killer third arrow is lacking the carry, June 13) saw hedge funds shorting the yen and going long the Nikkei, as well as a raft of currency-related trades.
Ever since the Fed initiated the QE programs markets have been characterised by extreme volatility as perceptions of risk have fluctuated and the concern is that rather than having a major stimulatory impact on the real US economy what it has done is to encourage and fund risky speculative activity and distortions in financial markets as investors have used the cheap access to funds to chase returns without much regard to risk.
Given the difficulty of identifying speculative bubbles within an opaque global financial system no one can be certain of how much risk to the stability of the system there might be within the shadow banking system but the amplitude of the recent volatility would suggest there is reason for concern.
Exiting from the QE programs was always going to be a delicate exercise to avoid the kind of market implosions that have occurred in the past when the Fed shifted monetary policy from an easing cycle to a tightening cycle.
This time, because of the unprecedented magnitude and unconventional nature of the program, it will be even trickier, and more dangerous.
Softening the markets up in advance for a gradual winding down of the programs would seem a sensible strategy. The response to Bernanke’s comments last month, however, underscores how easy it would be to create a destructive overreaction.
Next week’s FOMC meeting and the language in which its post-meeting statement is framed may provide further insight into how the Fed proposes to finesse its way through a difficult and potentially dangerous phase in the history of US monetary policy as the QE program nears its turning point.