The FED’s exit strategy

Ignacio de la Torre. Professor. IE Business School

26 June 2014

How fast is the Federal Reserve going to taper stimulus measures? Too fast and it could cause another recession, too slow and it could fuel high levels of inflation. 

Two years ago Bob Farrell said: “There are no new eras. Excesses are never permanent.”  Over the last few decades we have got used to excesses: excess inflation and employment in the seventies followed by successive bubbles of different types in the eighties and nineties; excess  debt as from the year 2000, which didn’t cause inflation of consumer prices but did cause inflations of asset prices, which in turn brought about financial instability that led to the crisis; and, as from 2009, we have seen overdependence on liquidity injected (and rightly so) by central banks to prevent financial meltdown.  

While Japan’s central bank injects the equivalent of 700 billion dollars into the economy each year, the balance sheet of the Federal Reserve has risen from the equivalent of 7% of GDP before the crisis, to slightly higher than 20% today.  Moreover, interest rates are close to 0%.  These monetary measures, perhaps the strongest ever applied in the history of the US, have achieved a great deal.

i) They have avoided a great depression like that of the thirties, which had a devastating effect on the finance system, on GDP, and on employment for more than a decade. ii)  They have enabled the US to recuperate the level of GDP it had before the crisis (in Europe we are still situated at 5% below the pre-crisis level), iii) unemployment in the US is now at levels that are very similar to short-term unemployment (the reduction in its labor force corresponds in large part to a demographic shift which is structural rather than circumstantial), and iv) the economy, following the winter lull due to the weather, is now growing at a rate of 4%  per annum, while the banking is system is now actively lending to the private sector, and there is a good rate of job creation.

Given that all positives have a negative side, we are now going to take a look at the risks associated with the fact that this success has been achieved using the abovementioned “tools”: i) a bubble in the price of assets is now emerging, as evidenced in the price of almost all types of bond, impacting variable income and the real estate sector, and threatening financial stability, and ii) it has generated an obvious risk of consumer price inflation caused by a) an increase in the balance sheet of the central bank which little by little is bringing about a rise in the money supply, which in turn could cause higher levels of inflation, b) a drop in unemployment levels in quite a few sectors, which has resulted in increases in wages, which is gradually causing inflation, and c) a progressive rise in banking loans to the private sector, which comes with a correlated rise in the speed of money (the number of monetary unit transactions over the course of a year), which in turn translates into greater levels of inflation.   

When comparing assets and liabilities, there is a massive debate at the FED about how to organize the “exit”, and how fast. For the moment, they are taking an approach based on tapering, or the reduction of the speed at which the FED buys assets to expand its balance sheet.  In the summer we will see a buying rate of some 10 billion, down from a maximum number of purchases of some 85 billion dollars per month. In other words, the FED’s balance sheet will grow far more slowly than nominal GDP, which means that its weight will gradually be reduced.

The hot topic, which has enormous repercussions for the entire world, is when to introduce rises in interest rates, and how fast they should effect an anti-tapering process, namely a reduction in the FED’s balance sheet to take it to more historic levels (7-8% of GDP).  If these contractionary monetary measures are carried out too fast, they could cause another recession, and if they are done too slowly, they could bring about high levels of inflation, which would ruin the FED’s credibility, which has taken so many years and so much effort to build.

There is consensus that tapering will come to an end in the fourth term of 2014,  and that interest rates will begin in the second quarter of 2015. It is not clear what the normalized rate will be, but it is expected to be somewhere in the region of 3.5% - 4%, probably sometime in 2016.  In fact, there are growing numbers of voices that say that central banks should tolerate higher than normal levels of inflation (Blanchard, of the IMF, is a supporter of this theory) which could mean that normalized rates will be lower. Nor is it clear how fast the FED will reduce the balance.

I believe that a more aggressive monetary policy carries more risks, due to the danger signs which are slowly starting to appear in the US in the form of inflation of consumer prices and asset prices. If this trend continues, the FED will have to react using different policies: a) raising interest rates at the end of this year, b) bringing forward the end of tapering, as well as starting to reduce the balance in absolute terms, and c) remunerating the FED banks’ reserves in order to reduce the inflationist impact of the liquidity generated over the last few years being invested too quickly in the private sector. Although this last measure can produce a great deal of social conflict in the US, it is a key issue, given the very high level of reserves of the FED banks (some three billion American dollars). If this money is put into circulation, it could have a terrible impact on money supply, and consequently inflation.

Such decisions would have major implications for all of us for several reasons. First, they will affect the value of US bonds, a value used as a base for the valuation of many assets worldwide. Second, it could have a serious effect on stock exchange indexes and bonds, given that we have never lived in a context in which central banks reduce their balances while raising interest rates. Third, it would increase flows of capital out of emerging countries in the direction of the US, thereby worsening the situation of emerging countries with current account deficits, like India, Turkey, or Brazil.

Such decisions, although dangerous on a market level, would send out a positive signal to the world, given that they would indicate that the US economy is continuing its recovery, which means that once more, the US will serve as the world’s engine through imports.    Nevertheless, it will mark the end of an excess, just as Farrell said would happen.  

The big question is who will bear the brunt of the fallout of this latest excess? 

 

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