US hints at turning down money tap

In: Uncategorized

19 Jun 2013

This is my Perspective column from this week’s Fund Strategy magazine.

Much of the debate on global financial markets in recent weeks, and indeed on economic prospects too, has focused on “tapering” by America’s Federal Reserve. Whenever such a term comes into vogue it usually repays examining in more detail.

It is clear what tapering means in principle. It simply refers to a reduction in monetary support by the Fed. Quantitative easing (QE) – or credit easing as the Fed prefers to call it – will be gradually phased out at some point. Much of the discussion so far has tried to ascertain when that point is likely to come.

The prospect of such tapering has certainly spooked the markets. Many equity markets have fallen from their recent highs and there has been a sell-off of bonds worldwide.

Yet central banks are notoriously cryptic about communicating messages about their intentions. Their preferred methods amount to a raised eyebrow here and half a wink there.

In retrospect the Fed’s discussion of tapering began to emerge with the Federal Open Market Committee (FOMC) in March. The statement released after the meeting referred to the Fed continuing to take account of the size, pace and composition of asset prices.

At the next FOMC meeting, as well as in subsequent congressional testimony by Ben Bernanke, the Fed chairman, the discussion became slightly clearer. In his statement he said that: “At its most recent meeting, the Committee made clear that it is prepared to increase or reduce the pace of its asset purchases to ensure that the stance of monetary policy remains appropriate as the outlook for the labor market or inflation changes.”

Although the discussion was posed in symmetrical terms it is clear that a Fed reduction in asset purchases looks much more likely than an increase. Bernanke was not exactly shouting it from the rooftops but he was signaling the possibility of a reduction in QE in the next few months.

At this point it is worth remembering the scale of state support for the economy in recent years. Official interest rates have remained in a narrow band of 0-0.25 per cent since late 2008. There have also been three rounds of QE with the latest as recent as last autumn. The Fed’s balance sheet has increased enormously as a result.

These measures amount to almost five years of considerable monetary support for the American economy. Indirectly it has also helped to shore up the global economy.

But the monetary side of state support is only part of the story. America has allowed its fiscal deficit to widen at the same time as allowing the Fed has pursued QE. Both fiscal and monetary policy have played a central role in keeping the American economy afloat in these difficult times.

At present it looks like fiscal policy will start to shift sooner than monetary policy. The federal government has already started to reduce its borrowing and is likely to continue to do so in the coming years.

The importance of this fiscal tightening was recognised by Bernanke himself in his congressional testimony:

“The expiration of the payroll tax cut, the enactment of tax increases, the effects of the budget caps on discretionary spending, the onset of the sequestration, and the declines in defense spending for overseas military operations are expected, collectively, to exert a substantial drag on the economy this year.”

This fiscal pressure helps explain the Fed’s current preoccupation with tapering. With the reduction in fiscal support already starting to get underway the central bank is trying to divine how far it can go in reducing QE.

Every Fed statement is therefore examined scrupulously for hints of future action. Data release, particularly those on employment, are also watched closely. The assumption is that a recovery in the jobs market could be the sign of a more general upturn.

Such obsessive Fed-watching probably makes sense for those involved in short-term market trading. A reduction in QE could indeed cause sharp movements in asset prices in America and beyond.

However, for anyone who takes a longer-term view it constitutes a problem. Obsessing over Fed actions obscures the importance of broader developments.

In particular there is a widespread assumption that America’s economic problems are essentially cyclical. When the economy starts to turn upwards then, so the argument goes, fiscal and monetary support for the economy can be scaled back. Everything can then go back to normal for a few years until the next downturn in the cycle comes along.

The problem with this view is that the current crisis is not simply a cyclical one. The authorities have engaged in widespread support for the economy, with slight fluctuations here and there, for at least three decades.

As things stand the prognosis is for a prolonged period of economic atrophy. Substantial state support for the economy looks set to continue although its efficacy is likely to be reduced. Every dollar of support is likely to have less impact than it did in the past.

The obsession over tapering reveals the narrowing of economic debate and the lack of long-term thinking about how to tackle the economic challenges facing America.