The beginning of the end of QE

The US stock market remains in a tizz over the prospect of the Federal Reserve scaling back its quantitative easing in the not too distant future. It is a perverse reaction given that the only condition on which the Fed has said QE will be scaled back is if and when the economy has improved and that that improvement is on a sustainable trend. 

US stocks fell 0.4 per cent overnight to register three straight falls that total 1.1 per cent. These are not large falls but rather reflect the fickle mood of the market.

The run of economic news in recent weeks has generally been better than the market has expected. This has focused the policy debate on the timing of the Fed tapering off its QE, which has been flagged by Fed chairman Ben Bernanke plus several other Fed officials.

The recent international trade data showed a solid lift in exports which will see second-quarter GDP growth revised up to around 2.5 per cent from the current 1.8 per cent. Last week’s labour market indicators showed the unemployment rate dropping to 7.4 per cent in July, a four-year low, which was welcomed by the market even if the pace of job creation in the month was a tad below expectations.

Other generally positive news on the economy is showing up in the housing market – prices, sales, and construction are all strongly above the levels they were a year ago. Indicators on consumer demand and sentiment are generally upbeat without being particularly strong.

The various business sentiment measures have been more positive – including the services sector Institute of Supply Management index which earlier this week surged to 56 points in July to indicate that economic growth probably accelerated into the third quarter. Even the manufacturing Purchasing Managers Index is solidly positive at 53.7 points. 

All of this suggests the US economy is moving from recovery to consolidation at a decent rate of growth and that, as a result, the degree of super stimulus coming from monetary policy will need to be scaled back, bit by bit.

Not helping the market at the moment is the range of comments coming from chatterbox Fed officials. The doves are saying that any thought of tapering off QE is still some time away and that the low inflation environment demands super easy policy. Meanwhile the hawks are keen to start the process of easing back on QE and to let the economy roll along more on its own steam rather than via the Fed printing money.

To be sure, the task of the Fed over the next years, perhaps decade, will be huge as it manages its $US3.529 trillion balance sheet and over the very long run, and scales it back, a point that Bernanke understands.

Scaling back the extra $US85 billion a month is obviously the first task of the Fed ‘deleveraging’ and the strength in the economic data suggests that the September meeting of the Fed will see this number cut.

The Fed is unlikely to go cold turkey on QE, rather reduce the $US85 billion by $US20 billion or so a month and then sit back and see how the markets and economy play out. It is difficult to be sure when the bond purchases will be phased out altogether – as it depends on the speed at which unemployment falls and inflation rises – but there’s a growing consensus that by this time next year, the Fed will be close to ending its bond buying activities.

The other arm of monetary policy is of course interest rates and it is now almost five years since the Fed shocked the world and set rates near zero. In all of the discussion of tapering off the bond buying program, no serious policy maker or economist is talking about the Fed hiking interest rates.

While sometime in the future interest rates in the US will rise, it is such a distant proposition that it is not adding to the debate to speculate about the timing of such a move.

Instead, the speculation is about the beginning of the end for QE. With a couple of more decent indicators on the economy, including another solid jobs report in the first week of September, and it would seem likely that the Fed will take a baby step towards scaling back QE at its September meeting of the Federal Open Markets Committee.

In the meantime, the markets will wax and wane with each hit of news, buoyed by signs of economic strength, but fearful that QE will soon end.