US Fed Tapering Postponed

Rama Krishna Vadlamudi, HYDERABAD 19 September 2013

Summary: The US Federal Reserve on 18 September 2013, at its Federal Open Market Committee (FOMC), decided to postpone its much talked-about tapering for the time being. This means the US Fed is maintaining its status quo of buying bonds worth $85 billion per month. It’s not clear when the Fed will start its tapering. With this flip-flop, the US Fed has made it difficult to predict when it will gradually reduce its bond buying program. Due to the moderate economic growth, low labor participation and recent rise in mortgage rates, the Fed has decided to postpone the tapering decision. With this decision, the US dollar is down, gold price is up, and stock markets too have cheered the Fed decision.
What is Fed Tapering? Before we move further, let us see what is meant by Fed tapering. Tapering means to reduce gradually. In May this year, the Fed had hinted that it would decrease its monthly bond buying program (See more on QE3 at this end of this post) at a measured pace. At that time it was perceived that the tapering would start in September this year and would end by the middle of 2014. The markets had taken this news of US Fed tapering very negatively. Even though attempts were made to assuage the markets subsequently, the market perception did not change. The US Fed, the IMF and the ECB tried to calm the nerves of financial markets, by saying that they’d continue with their easy money policies as long as their economies remain weak.

Rama Krishna Vadlamudi, Hyderabad 19 September 2013

This Fed’ hint of tapering its bond buying created a flutter in the financial markets. The yield of US 10-year Treasury increased from 1.6% in May 2013 to 3% in early September 2013. There was huge sell-off in securities, both shares and bonds, in the EMs resulting in huge outflow of money from EMs back to the developed markets. Against the US dollar, currencies in the EMs have depreciated very sharply—ranging from eight to 12 per cent. Why did the Fed decide to postpone the tapering? As clarified by the Fed chairman Ben Bernanke there are three main reasons for its decision to continue with its bond buying and postpone the tapering: 1. Labor force participation rate has declined—partly reflecting potential workers getting discouraged. Though the unemployment has fallen to 7.3 per cent, the fall is substantially due to people leaving the labor force. 2. There is a tussle in the US congress over passing of a bill to keep the government funded (if there is no agreement between the Republicans and the Democrats, it may lead to a government shutdown in the US). This tussle may dampen the economic growth. 3. Mortgage rates in the US have gone up recently (after the hint of tapering) The status quo remains for the time being: As far as the financial markets are concerned, the status quo remains for the time being. There is no change in the QE. The Fed will continue with its buying program at the current levels. In the words of FOMC: “However, the Committee (FOMC) decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.” This implies that the US economy is still facing challenges and the monetary stimulus is still necessary for achieving maximum employment and price stability. To stimulate the economy, the Fed will continue to print money.

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Rama Krishna Vadlamudi, Hyderabad 19 September 2013

What is the state of the US economy? The US economy is improving, but at a moderate pace. The unemployment rate remains high even though there are positives in the labor market. Some improvements in the economy are: increase in household spending, growth in fixed investment and strengthening housing sector. Inflation is as per expectations. On the negative side, mortgage rates have gone up recently and the economic growth is constrained by fiscal policy. In the last one year, unemployment rate has fallen from 8.1 percent to the current 7.3 percent and about 2.3 million private-sector jobs have been created. One of the reasons for dip in the unemployment rate is the decline in labor force participation rate owing to people exiting the workforce. When will the Fed start its tapering? Between May 22nd this year when the Fed hinted at tapering and now, the financial markets—bond, stock, currency and commodity—have undergone immense volatility. EMs were subject to large outflow of funds. The Fed decision not to taper has taken the financial markets by surprise. In the last 12 to 14 hours, the global stock markets have gone up thinking that the Fed stimulus will increase fund flows into financial markets and EMs. The tapering decision is now postponed. What lies ahead? When will the Fed start reversing its easy money policy? What is the timeline for the Fed to start raising the federal funds rate? The answers remain elusive. The Fed’s aboutturn is bound to confuse the markets, making it difficult to forecast the future Fed decisions. The Fed will keep its focus on US economic growth and unemployment rate. The Fed’s projections indicate the US economy may grow between 2.0 to 2.3 percent in 2013, rising to 2.9 to 3.1 percent in 2014 and 2.5 to 3.3 percent in 2016. The unemployment rate may decline to 6.4 to 6.8 percent in 2014 and to 5.4 to 5.9 percent by 2016. Inflation may remain between 1.1 and 1.2 percent in 2013; 1.3 to 1.8 percent in 2014; and 1.7 to 2.0 percent in 2016. Overall, the Fed is expecting a moderate recovery in the US economy and its future monetary policy will be based on fostering maximum employment and price stability. My overall feeling is that the US would not be able to start tapering for another 12 to 18 months.

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Rama Krishna Vadlamudi, Hyderabad 19 September 2013

When will the Fed start increasing the federal funds rate (fed rate)? Another persistent and relevant question that bothers the markets is when the Fed will start increasing the fed rate. The fed rate has been kept at a record low of 0 to 0.25 percent since December 2008.
Related: The Fed rate has been cut to record low What is the difference between US Fed rate and US Discount rate

The Fed has linked its bond buying program to the outlook for the labor market. So, any decision on a tight money policy, that is raising the federal funds rate, will depend on the labor market conditions. The Fed is committed to continuing the fed rate at record lows as long as the unemployment rate remains above 6.5 percent, and so long as inflationary expectations are well under Fed’s comfortable levels. The Fed is categorical that a decline in the unemployment rate to 6.5 percent would not lead automatically to an increase in the fed rate. Once the unemployment rate goes below 6.5 percent, it will take a decision on the revision of fed rate keeping in mind the overall economic outlook and labor market conditions, especially job gains. In the words of the US Fed: “…the first increases in short-term rates might not occur until the unemployment rate is considerably below 6.5 percent.” Market Reaction: The US Fed has been welcomed by the world’s financial markets. The market perception is that the money taps will continue to be kept open by the central banks. The US stock indices have gone up by around one percent clocking record highs. The Asian stock markets have gone up by two to four percent. The US dollar is down, while gold and oil prices are up. Conclusion: The Fed has flagged certain fiscal policy problems for the US economy. It is concerned that these problems could be detrimental to the economic growth. There is an ongoing controversy in the US congress over government funding deadline of 30th September. These may entail certain risks for the markets in the coming weeks or months.

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Rama Krishna Vadlamudi, Hyderabad 19 September 2013

The fact that the Fed will continue to print money seems to have cheered the markets. However, there is one dissenting voice in the FOMC. Ester George, one of the FOMC members has cautioned that the massive bond buying program may result it future economic and financial imbalances and higher inflation. The real problem is that the markets may react violently again when the Fed decides to start tapering. In fact, the admission that the US economy’s growth has moderated should be a negative in the medium term for the markets. But, the markets are currently happy with the Fed decision. I think market will have to realize the larger picture at some point in future. The reality is that one day these central banks have to stop their massive liquidity injection programs, resulting in large money outflows from emerging to developed markets. We need to keep our focus on the ensuing economic indicators. Related: Emerging markets are down but not out
References: FOMC press release dated 18Sep2013 Bernanke’s press conference Photo courtesy: US Federal Reserve. Abbreviations: BoJ – Bank of Japan DMs – Developed Markets ECB – European Central Bank EMs – Emerging Markets IMF – International Monetary Fund

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Rama Krishna Vadlamudi, Hyderabad 19 September 2013

Additional Reading
I. What is QE3? After the 2007/2008 global financial crisis, the Fed has been trying to stimulate the US economy with its easy money policy. The Fed has been following an unconventional monetary policy of buying bonds called quantitative easing (QE) as it cannot further lower the current federal funds (fed rate) target of 0 to 0.25 per cent. In the last six years or so, the Fed has increased its monetary base by almost four times as part of the QE, whereby it buys bonds from commercial banks and other financial institutions. This is aimed at decreasing interest rates and boosting the US economic and job growth. As part of its quantitative easing (QE) program started in September 2012, the Fed has been buying bonds worth $85 billion per month—consisting of US Treasury securities worth $45 billion and mortgagebacked securities (MBS) worth $40 billion. This is the third version of the program, called QE3. In the first round of quantitative easing (QE1) between November 2008 and March 2010, the Fed bought MBS worth $1,250 billion and agency MBS worth $175 billion, in addition to purchase of US Treasuries. In the second round (QE2) between November 2010 and June 2011, the Fed bought US Treasuries worth $600 billion. Officially, the QE program is known as large scale asset purchases or LSAPs. In layman’s lingo, the QE has increased money supply by leaps and bounds in the banking system, resulting in massive printing of US dollars. This tremendous liquidity has flown out of the US and reached several financial centers around the globe, inflating prices of commodities, EM securities and other asset classes. II. What monetary policy instruments are used by the US Federal Reserve? In normal times the Fed eases monetary policy by lowering its target for the short-term policy interest rate, known as the federal funds rate, or fed rate. For more than 50 years, the Fed has used the fed rate as a conventional monetary policy tool. In December 2008, the Fed decreased the fed rate to a record low of 0 to 0.25 percent. After that, the Fed was forced to use other unconventional tools at its disposal, due to the fact that current federal funds rate of 0 to 0.25 per cent could not be lowered further. So, how could the Fed signal interest rates in the economy?

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Rama Krishna Vadlamudi, Hyderabad 19 September 2013

Since the latter part of 2008, the Fed has been using the following two tools: 1. Large scale asset purchases, commonly known as quantitative easing, whereby the Fed has been buying US Treasuries, MBS and others; and 2. Forward guidance about short-term interest rates; that is, communicating its plans for setting the fed rate target over the medium term. III. What is the mandate of the US Fed? As per the Federal Reserve Act, the statutory objectives for monetary policy are: maximum employment, stable prices and moderate long-term interest rates. The Fed tries to target inflation rate at two percent. Further, the objectives of the monetary policy should be explained to the public as clearly as possible fostering better communications; enhancing transparency and accountability; and reducing economic and financial uncertainty. IV. Why is US inflation not rising despite increased money supply? Even though the Fed has increased its balance sheet by almost four times in the last six years, there has been no alarming increase in the US inflation. This is due to the fact the US commercial banks’ lending growth is sluggish.
--Disclaimer: The author is an investment analyst, equity investor and freelance writer. This write-up is for information purposes only and should not be taken as investment advice. Investors are advised to consult their financial advisor before taking any investment decisions. He blogs at:
Tweets @vrk100

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