When is it the Fed’s cue to leave?
The Federal Reserve’s second round of quantitative easing to the tune of $600bn put a firework under a trend that started back in August when Fed Governor Ben Bernanke first touted the idea of providing more monetary policy support to the US economy. Risky assets are in demand and the market is happy to sell dollars.
After digesting the Fed’s statement released after its meeting, investors aren’t willing to stand in the Fed’s way as it keeps its hand on the monetary policy trigger: “The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.”
But should investors worry that this euphoria in asset markets will end in tears? It was, after all, William McChesney Martin Jr., the longest-serving Fed President, who said that the job of the Federal Reserve is “to take away the punch bowl just as the party gets going”. The question is, what will Ben Bernanke do with his punchbowl? This is even more in focus after a strong October payroll report.
There are a number of risks with QE2 that investors should bear in mind while they are riding the wave of Fed liquidity. Firstly, inflation. Monetary stimulus has pushed down the value of the dollar, which pushes up the price of commodities. This causes inflationary pressure to build at the start of the pipeline, which will eventually feed into consumer prices. Once inflation looks like it could exceed the Fed’s threshold (around 2 percent) it will trigger tightening by the central bank. This is when a reversal will occur in the financial markets and bond yields rise as the price of Treasuries start to tumble.
But Ben Bernanke, writing an opinion piece for the Washington Post s, argued that QE1 (at the peak of the financial crisis) didn’t cause price increases to accelerate. But QE1 was to avoid a liquidity crunch and ensure the smooth running of the financial markets. This time, financial markets aren’t in distress and the economy is growing, albeit below the rate the Fed deems acceptable. In the same piece, Bernanke said the Fed is confident that it will have the tools to unwind these policies at the appropriate time. However, he also mentioned that asset purchases are relatively “unfamiliar as a tool of monetary policy”.
The truth is that the Fed doesn’t know what its exit policy will look like since it has pledged to re-invest the proceeds of assets purchased under QE1, rather than sell them back to the market. When it finally decides the time is right, the Fed’s exit programme will need to be handled with extreme care. It has already had to relax System Open Market Account (Soma) limits, which restricts it from buying more than 35 percent of any single issue in US Treasuries. QE2 heralds the Fed as a huge force in the US Treasury market, and the prospect of price distortions are great. But the Fed will want to leave the market with as little fuss as possible so as not to cause a huge spike in bond yields. To do this it needs to ensure the timing is perfect, which may end up delaying the Fed’s eventual exit.
Lastly, it’s worth remembering that it may not be the Fed who ultimately decides the timing of its asset sales. A year ago US authorities were called to explain to China, one of the largest holders of Treasuries, how it would manage its exit strategy from QE1 and deflect any criticism that it was trying to monetize its massive debt. So far the Chinese seem more concerned that QE2 will stoke asset price bubbles in its economy, but concerns about 1, the Fed monetizing the gigantic US debt, and 2, a sharp rise in inflation eroding the value of their Treasury holdings must be keeping some officials in Beijing awake at night.
While inflation concerns are already being priced into the market - 5-yr inflation-protected Treasuries have been selling with negative yields – the risk of a mis-step by the Fed that causes a spike in bond yields and the prospect that China may want a say in the Fed’s exit strategy are not currently on the market’s mind.