Rather than panicking, the market should be jumping for joy

Ahead of the US Federal Reserve's mysteriously market-rocking monetary policy announcements, New York's Business Insider website listed its top nine songs about monetary policy.

Ahead of the US Federal Reserve's mysteriously market-rocking monetary policy announcements, New York's Business Insider website listed its top nine songs about monetary policy.

Velvet Underground's Waiting for the Man got a nod, of course, along with Heart Shaped Box by Nirvana ("Hey! Wait! I got a new complaint/ Forever in debt to your priceless advice"), and Debaser by the Pixies ("Wanna grow up to be a debaser").

The Beatles took out the No. 1 slot with Tomorrow Never Knows, in which they advise us to turn off our minds and surrender to the void.

For me, however, Jim Morrison hit the spot in 1970 in the third track of the Doors' classic album, LA Woman. "I've been down so very damn long that it looks like up to me," Morrison wailed. "Yeah, why don't one you people/ C'mon, c'mon, c'mon and set me free?"

The only way to explain the negative market reaction to Federal Reserve chairman Ben Bernanke's announcement of the probable timing of the withdrawal of quantitative easing that is running at $US85 billion a month, and a subsequent move to raise benchmark short-term interest rates, is that the cost of money has been down at record lows for so long that, rather like the late Jim Morrison, investors think even a conditional timeline for the withdrawal of stimulus is akin to a ruinous rate hike. In fact, it's good news - a sign that the world's biggest economy is kicking free of the great financial crisis.

The Dow Jones Industrial Average lost 206 points, or 1.35 per cent, on the Fed's news, and in a descent spurred by the release of soft manufacturing data in China, the Australian dollar fell by 3.1 per cent and Australia's S&P/ASX 200 Index fell by 2.1 per cent.

What the Fed really did however was replace speculation and uncertainty with calendar entries.

It made no changes to rates or the QE cash-splash, but upgraded its economic growth forecasts. Then, at a press conference, Bernanke confirmed that the Fed would respond to the resurrection of the US economy by carefully backing out quantitative easing, and then, and only then, by pushing short-term reference rates higher.

QE could begin shrinking later this year and be over by the middle of next year, he said. The Fed's short-term reference rates would, however, stay at 0 per cent effectively for a "considerable" time after that, until the Fed was convinced that unemployment was down from around 7.6 per cent to 6.5 per cent or less, and that the economy was running at "a reasonable cruising speed".

Nothing was locked in, he stressed. The 6.5 per cent unemployment rate was a "threshold", not an automatic trigger, and as it reduced QE ahead of any rate rise, the Fed would be constantly assessing the economic impact. If America's recovery was faster than expected, QE could be withdrawn more quickly. If it was slower than expected, QE would retreat more slowly. If the economy stalled, QE could actually rise.

The central timetable for the withdrawal of QE may be more aggressive than some in the markets hoped. It is, however, pretty much as expected. Bernanke has cut through uncertainty and speculation about the timing of a monetary tightening, linked it to economic growth, and remarked along the way that inflation is not a threat. There's just not enough in that to warrant a market tantrum.

The key of course, so often forgotten when monetary policy begins to tighten, is that the tightening is a response to economic growth. The benefits of that growth far outweigh the market effect of the tightening in time.

As US monetary policy tightens with the withdrawal of QE and the shift to a rising interest rate cycle gets closer, Australian interest rates also become less like international currency catnip for global investors.

Thursday's 3.1 per cent slide in the value of the $A from US95.35¢ to US92.4¢ late afternoon overstated the currency market reaction. What really happened was that the $US rose; other currencies were down against the greenback, and the $A trade weighted index was down by a less hysterical 1.8 per cent.

The $A's 12.5 per cent fall in both $US and TWI terms in the past six weeks is, however, great local news. It makes Australian exports more competitive and raises the local price of imports, shortening the odds on the non-resources sector accelerating to fill the gap a receding resources boom is creating. Reserve Bank cash-rate cuts become less likely, but the $A would need to fall another 10 per cent to take cash rate cuts totally off the agenda.

Two final thoughts for the doom and gloomers. Even after being pounded on Thursday, the $A is still worth what it was in September, 2010. And while 10-year US government bond yields have risen by three-quarters of a percentage point in seven weeks in anticipation of a Fed tightening, they are still very low, at 2.37 per cent. They rose by only two basis points, or 0.02 per cent, on the Fed announcements: hardly a reaction of shock and awe.

mmaiden@fairfaxmedia.com.au

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