The markets' multi-trillion dollar question for the Fed

The Federal Reserve is aware of the challenges it faces in ending QE without triggering another crisis, but markets have already focused their attention to the timing and magnitude of a rate rise.

The minutes of the Federal Reserve Board’s Open Market Committee’s June meeting make it clear that the central bank plans to end its purchases of bonds and mortgages in October. The multi-trillion dollar question that remains is when it will start raising US interest rates.

That’s a potentially critical question because it will impact other central banks and financial markets that have become addicted to the flood of cheap liquidity provided by the Fed since it began its quantitative easing programs in December 2008. Since then it has expanded its balance sheet by more than $US3 trillion.

While there was a lot of discussion at the meeting about the mechanics of 'normalising' US interest rates and exiting the abnormal monetary policy settings -- at present the Fed’s target range for the federal funds rate is at zero to 0.25 per cent -- there was no clear sense of when the first rate increase might occur. Twelve of the 16 committee members, however, thought the appropriate timing for the start of 'policy firming' would be next year.

The timing and nature of that first step towards normalising US monetary policy will be a delicate one. As discussed yesterday (Scentre stage to the search for yield, July 9), it's one that financial markets are likely to pre-empt even though the committee appears committed to maintaining its target federal funds rate at below levels it views as normal for "some time" after rates begin to shift up.

While the Fed’s chair, Janet Yellen, has dismissed calls for central banks to begin using monetary policy to reduce the threat of asset price bubbles, instead arguing for the deployment of ‘’macroprudential’’ measures, it is apparent that there is some unease within the committee about the state of financial markets.

"Participants also discussed whether some recent trends in financial markets might suggest that investors were not appropriately taking account of risks in their investment decisions," the minutes read.

‘’In particular, low implied volatility in equity, currency and fixed income markets as well as signs of increased risk-taking were viewed by some participants as an indication market participants were not factoring in sufficient uncertainty about the path of economic and monetary policy."

The absence of volatility across global financial markets implies a general complacency about risk. However, one could argue that asset prices have been supported and heavily inflated by the unconventional monetary policies of central banks, which have pushed investors into an increasingly aggressive search for positive returns and encouraged global carry trades predicated on access to ultra-cheap credit. If there are asset bubbles within the global system, the Fed and its peers have helped create them.

While Yellen has advocated the use of macroprudential tools (the committee described them as "supervisory measures"), the difficulty for regulators is that much of the more aggressive activity is occurring outside of the banking system, where macroprudential measures might be expected to have the most effect.

Banks already face a raft of macroprudential regulations via their capital and liquidity requirements and, in some jurisdictions, specific controls on loan-to-valuation ratios and the like.

Now that it appears near-certain that the Fed’s five-year QE experiment will end in October, attention will turn to the timing and magnitude of the first upwards movement in US rates for five years.

There had been a view in markets that the Fed wouldn’t move until 2016, and there are still three members of the committee who’d prefer that timing. But the markets will now have to start guessing where that first rate rise might fall within 2015.

Obviously that will hinge to a large degree on how the Fed reads the state of the US economy. There appears to be a view in the market that it might move in the middle of next year if economic conditions continue to improve. If markets continue to exhibit their current version of 'irrational exuberance' and complacency, the pressure for the Fed to do something earlier could increase.

The closer we get to 2015 and the start of the Fed’s unwinding of its current policies, of course, the more markets will focus on the likely path to normalisation and begin to factor that into pre-emptive decision-making.

It is conceivable that sometime between now and that first rate increase that volatility in markets will increase. To the extent that there are asset price bubbles out there, they will begin to deflate -- or implode if everyone rushes for the same exit at the same time.

The Fed faces a challenging period trying to gradually exit from its massive QE programs without triggering another financial crisis in the process. It is obvious from the minutes that it is aware of the difficulty and delicacy of the task. But it’s not quite as obvious that it is as focused on the implications of its shift on global financial markets as it is on the implications for the real economy in the US.

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