Have markets finally received Bernanke’s taper message?
Thanks goodness it’s over. Financial market behavior ahead of last night’s announcement by Ben Bernanke on a gradual reduction in U.S. monetary stimulus has been tedious and irritating, rather like listening to whining children in the back of the car on a long journey: “Daddy, are we there yet?” In fact, impatient whining about when the Fed might start to “taper” has spoiled for many investors what should have been one of the most enjoyable financial journeys of all time, scaling previously unexplored market peaks and passing through unprecedented monetary vistas.
Imagine if everyone had simply taken Ben Bernanke at his word when he said in May that the Fed would continue buying bonds at the rate of $85 billion every month until it was absolutely confident that unemployment was on the way to 6.5 percent and that the scale of these purchases would only be increased or diminished if and when a change was clearly warranted by economic statistics. Investors would then have concluded, as I suggested at the time, that no significant changes in U.S. monetary policy were likely until the end of 2013.
Stock markets around the would have enjoyed their strongest year for a decade without the trauma of the spring and summer “taper tantrum.” Nobody would have been shocked or embarrassed by the “September surprise,” when the Fed very sensibly decided to keep up the pace of monetary stimulus in the face of lackluster economic figures, despite the howls of indignation from analysts who were wrong-footed by their own unsubstantiated predictions of early tapering. Finally, investors would have been fully prepared for the Fed’s decision to go ahead with tapering this week. After all, the recent strong run of U.S. employment, housing and production data provided exactly the sort of strong economic background that Bernanke had posited all along as the necessary condition for tapering, especially in conjunction with the Congressional budget deal that was ratified by the Senate at the same moment Bernanke as spoke across town.
Which brings us to the implications of this week’s momentous events in Washington for economic and financial prospects. For the U.S. economy, the combination of Fed tapering and overwhelming support in both houses of Congress for the budget deal is unambiguously good news. The uncertainties over monetary and fiscal policy that have dominated business, consumer and financial sentiment since the 2008 financial crisis are now essentially resolved. The budget deal virtually guarantees stability in both taxes and public spending until at least 2015 and probably until the next president is inaugurated in January 2017. Meanwhile, the addendum to the Fed’s tapering announcement, which promised to maintain interest rates at their present level until “well past the time that unemployment declines below 6.5 percent,” virtually excludes any possibility of monetary tightening until well into 2015 and represents a much stronger and clearer commitment to near-zero interest rates than anything previously heard from the Fed.
Most importantly, the Fed has now made absolutely clear and unambiguous the two key messages that Bernanke spent this year trying to explain to the markets. First, that a gradual slowdown in the Fed’s asset purchases does not imply any chance in the outlook for interest rates and the Fed will ensure that short-term rates remain firmly anchored near zero. Second, that U.S. interest rates will only start to rise after the U.S. economy has been restored to something approaching full employment — and given the millions of discouraged workers who have recently dropped out of the labor force, the restoration of full employment is likely to require several years of rapid growth, at well above the U.S. economy’s long-term trend growth rate.
Thus U.S. monetary conditions are now virtually guaranteed to remain extremely stimulative until after the economy has achieved a long period of above-trend growth. This means that, before the Fed even starts to think about an increase in interest rates, U.S. GDP will have to grow by around 3.5 to 4 percent for at least a year or two. This may sound wildly ambitious, compared with the past four years’ 2.4 percent average growth rate. But actually 3.5 to 4 percent growth is a very modest objective. In fact, the U.S private sector, excluding the effects of government spending cuts, has already been growing by an average of 3.4 percent since late 2009. Total GDP growth has been a full percentage point lower because of the effect of government spending cuts. But with the political clamor for public spending cuts now subsiding, even within the Tea Party, U.S. fiscal policy has shifted into neutral — and fiscal neutrality brings 3.5 to 4 percent GDP growth well within reach.
For U.S. economic activity and employment, therefore, the combination of Fed tapering, budget stability and the Fed’s unambiguous commitment to zero interest rates looks like very good news. For financial markets, there is more ambiguity, as always, even if the U.S. economy accelerates as described.
Stronger U.S. growth will put upward pressure on long-term interest rates, even if the Fed keeps its promise to anchor short rates at or near zero for the next several years. Even though a large part of the upward adjustment in long-term interest rates has probably already happened, bonds and other fixed-interest securities are likely to suffer to some extent as the economy accelerates. This will create something of a headwind for equities and property prices, although history shows that during economic upswings, the benefit to equity prices from stronger economic activity and revenue growth normally outweighs the pressure from rising long-term interest rates.
A second challenge for financial markets is that Wall Street, the most obvious beneficiary of stronger U.S. economic activity, is now the world’s most expensive stock market. Because accelerating U.S. growth is likely to reinforce a global economic recovery, equities in Europe and Asia, many of which are still priced for economic stagnation, could well outperform Wall Street, where a fairly strong economic recovery may already be “in the price.” If this happens, then the Fed will be confirmed yet again as the world’s central bank.
PHOTO: U.S. Federal Reserve Chairman Ben Bernanke readies his notes as he begins his final planned news conference before his retirement, at the Federal Reserve Bank headquarters in Washington, December 18, 2013. REUTERS/Jonathan Ernst