American Impact Time for Fed to Return to Normal Monetary Policy

Cape Times (South Africa), November 6, 2013 | Go to article overview

American Impact Time for Fed to Return to Normal Monetary Policy


BYLINE: Sandy McGregor

Despite the US Federal Reserve's decision in September not to begin to reduce its support of the US market and the economy, the US - and, indeed, the world economy - is in a sufficiently robust condition for the unconventional policy mix of quantitative easing (QE) and zero interest rates to be brought to an end.

Occasionally, financial markets become obsessed with a particular issue. An inordinate amount of analysis and commentary is being devoted to when and how the US Federal Reserve will end its present programme of quantitative easing.

QE, which can be described as printing money, sees the Fed buying $85 billion (R863bn) of mortgage and government bonds monthly.

This is the third time since the 2008 financial crisis that the Fed is massively increasing the size of its balance sheet. In 2008 it injected $1.3 trillion into the financial markets when liquidity disappeared following the collapse of Lehman Brothers. Then between October 2010 and June 2011, it injected a further $570bn in a programme now known as QE2. In December last year, it launched QE3. In contrast to QE2, this programme is open-ended.

When, and only when, the US economy is judged to be sufficiently buoyant will the Fed curtail and then cease buying bonds. It wishes to see unemployment below 6.5 percent. This exit process has been called "tapering" because the Fed plans to gradually reduce its monthly purchases as circumstances allow.

QE2 and QE3 have had a similar outcome. The money created has not stimulated any increase in bank lending. Since growth in bank credit is the normal transmission mechanism by which monetary policy affects the real economy, it can be argued that QE has not had a significant impact on economic activity. The money has largely ended up as cash deposited by banks, mainly foreign, with the Fed.

Proponents of QE argue that in a world of zero interest rates, the transmission mechanism acts by boosting asset prices and thus the confidence of homeowners and investors.

During QE2, the Fed expanded its balance sheet by 24 percent and share prices, as measured by the Standard & Poor's 500 index, rose by 23 percent. So far during QE3, a 27 percent increase in the central bank balance sheet has been accompanied by an 18 percent rise in share prices.

Property prices are recovering. The rise in asset prices has restored household balance sheets to a healthier situation compared with what existed before the crisis, thus boosting confidence, which is needed for sustainable economic growth.

In addition to QE, the Fed has kept short-term interest rates at close to zero since 2009 and has indicated that they will remain there into 2015.

This constitutes a massive financial repression of savers. In a desperate search for returns, investors have pushed government bond yields to levels not seen since the late 1930s. In November 2012, the yield on the US 10-year government bond fell to 1.58 percent and the 30-year bond to 2.77 percent.

Proponents of these policies argue they are necessary and are having a positive impact. Critics say any benefits are temporary and the exercise distorts prices, which will have to adjust to reflect underlying realities.

Over the past six months markets have focused on the inevitable ending of this programme. The US economy survived going over the "fiscal cliff" between January and April this year when previously legislated tax increases and government spending cuts were implemented.

The fiscal cliff was a non-event, with predictions of disaster proving unwarranted. There is evidence the US is in a strong enough condition to end QE; the next step will be to revert to more normal interest rates.

Market participants are concerned about when and how QE will end. The Fed is holding down the yield on mortgage bonds. It is also buying about 70 percent of the US government's new debt issuance. …

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