The Fed seems to be facing two major risks: first, premature tapering disrupting markets and triggering global turmoil across asset classes, thereby threatening the fragile economy recovery; second, delayed tapering further fuelling asset price bubbles, which could burst eventually and do major damage. UBS' Beat Siegenthaler notes the September decision suggested a Fed more worried about the fragile recovery than about the potential for asset bubbles and other longer-term problems associated with extended liquidity injections. Whereas it had originally assumed that a gradual tapering would result in a gradual market reaction, Siegenthaler explains it is now clear that the situation is much more binary; and as such, the hurdles for tapering might be substantially higher than originally thought.
Central bankers seem more powerful than ever, yet also more divided and confused than for a long time. This may be particularly true for the Fed, as it struggles with how to exit unconventional policies without creating major global market turmoil. In September it shied away from reducing monthly QE purchases, surprising both markets and central bank colleagues around the world. UBS Economics now expects tapering to start in Q1 2014 with the January meeting seen as somewhat more likely than the March meeting. The risks to this call, though, seem almost entirely on the dovish side as a December move would be tantamount to admitting that September was a mistake given the likely lack of decisive data until then. For the dollar, this could keep things difficult for some time.
Why did the Fed decide to hold back in September, deeply puzzling investors who had very widely expected a move, and thereby putting the credibility of its communication strategy at risk? It appears that two arguments were decisive:
First, the recovery was seen as still too fragile to withstand the level of market turmoil that had developed following the taper talk in early summer.
Second, the looming government shutdown and debt ceiling were seen as seriously clouding the fiscal outlook.
Relatively soft economic data since the decision have so far seemed to vindicate the decision as has the subsequent political turmoil in Washington.
However, many observers, particularly in Europe, have been critical on the political aspect of the decision as the FOMC seemed to 'bail out' the politicians and thus risk creating moral hazard. It would seem fair to say that the ECB, for example, would have acted rather differently in similar circumstances. President Draghi's pledge in summer 2012 to do 'whatever it takes' was the exception to the general ECB rule that monetary policy is not there to address structural problems that are the politicians' responsibility. In Frankfurt, nonconventional policies are seen as something to get rid of as soon as possible rather than something to retain as an insurance policy. It was no coincidence that in June this year Draghi said with quite some satisfaction that 'we, unlike other central banks, can gradually downsize our balance sheet without having to take any decisions that would, or could, create volatility'. This, clearly, is not a luxury the Fed has.
...and looking forward
The Fed is facing two major but opposing risks:
first, premature tapering could unleash market turmoil that could threaten a still fragile recovery;
second, delayed tapering could further drive up the cost of the inevitable QE exit.
The emerging market collapse in early summer may have been just a harbinger of what could come once central bank liquidity injections end. Some observers have argued that the market will react in a more relaxed manner to the next round of taper talk as the issues would be familiar. However, this might be too optimistic a view. Equity markets have continued to rally with the S&P reaching new record highs while 'carry' currencies such as the Australian dollar have regained lost ground, even though the advance has since been capped by the October FOMC statement not shutting the window on early tapering. Given that it has generally been a lacklustre year for most investors, the pressure is to jump back into riskier trades and generate some more performance before year end, even if the tail risk of early tapering might continue to loom. In this situation, any piece of weak data and any dovish communication could push tapering expectations further out and lure investors back into risk, thereby increasing the cost of the inevitable exit.
Linear vs. binary
Ideally, the Fed would gradually exit QE as the recovery gradually gains ground. Indeed, this seems to have been the idea behind the tapering talk in early summer, trying to prepare markets for an initial step later in the year. The belief had been that what investors cared about was the stock of QE purchases, i.e. the overall size of the Fed's balance sheet. As it turned out, however, investors seem to care about the flow of QE purchases instead. Or even worse, they seem to hold a binary view, equating the start of tapering to the end of QE, which means positioning does not adapt in linear, but an abrupt way. It therefore does not matter much whether the initial reduction would be $10bn or $20bn as the market would read any move, whatever the number, as a signal that the monetary policy super tanker had started to turn. Or as St. Louis Fed President Bullard put it last week, “changes in the pace of asset purchases have a very similar financial market effect as changes in the policy rate during more normal times”, meaning that any tapering acts very much like a conventional rate hike. “The Committee needs to either convince markets that the two tools are separate, or learn to live with the joint effects of tapering on both the pace of asset purchases and the perception of future policy rates”. Bullard seems to believe that the Fed has to live with the joint effects, which would suggest that the hurdle for tapering is much higher than initially thought.
A clash of central banking traditions
So what should the Fed do? Few central bankers would dispute that there are risks to keeping nonconventional policy measures in place for an extended period of time. In fact, the marginal benefits in terms of the economic impact seem to be declining, while the risks in terms of asset bubbles and other distortions seems to be increasing. Many would also argue that keeping 'emergency measures' in place beyond the actual 'emergency' sends out a bearish signal to investors, keeping confidence down. Central bankers in the European, or more specifically the Bundesbank tradition, would thus argue that given the doubtful benefits of QE together with the increasing longer term risks, the policy should be stopped as soon as possible. The Anglo-Saxon tradition, however, would seem more willing to use asset prices as a tool to support economic activity, and have a higher willingness to accept the risk of bubbles. Indeed, a fear of an asset price shock appears to have been what kept the Fed from taking the plunge in September, and might continue to hold them back for some time. The majority of the FOMC might be seeing propping up asset prices as a second best way to keep sentiment up, in the absence of a convincing economic recovery as the first best solution.
A pessimist might see the Fed facing a lose-lose situation, a veritable policy trap. The only scenario in which a relatively painless escape from the trap would be possible is one in which the economic recovery gains ground and becomes robust relatively quickly. This seems exactly what equity markets are pricing in, i.e. a world in which global economic activity will seamlessly take over from QE as a driver of risky assets. UBS Economics has been drawing a picture that looks fairly close to such a benign scenario, expecting a slow but steady acceleration of global growth over the next two years. Monetary policy accommodation could then be withdrawn gradually, avoiding substantial market turmoil (UBS Global Economic Outlook 2014-2015, 28 October). Viewed from this perspective, the likelihood of the Fed unduly fuelling asset bubbles might thus be considerably higher than the one of prematurely reducing QE and triggering market turmoil, particularly as the track record of the Bernanke Fed, as well as the reputation of incoming Chair Yellen, would suggest that monetary policy in the US will err on the easy side for some time to come. All of this might continue to support risky assets and weigh on the dollar, but also increase the risk of a crash once QE inevitably comes to an end.
The Fed seems to be facing two major risks: first, premature tapering disrupting markets and triggering global turmoil across asset classes, thereby threatening the fragile economy recovery; second, delayed tapering further fuelling asset price bubbles, which could burst eventually and do major damage.
The September decision suggested a Fed more worried about the fragile recovery than about the potential for asset bubbles and other longer term problems associated with extended liquidity injections. Whereas it had originally assumed that a gradual tapering would result in a gradual market reaction, it now appears that the situation is much more binary. If so, the hurdles for tapering might be substantially higher than originally thought.
For investors, the situation is a very challenging one: should they position for a QE world in which risky assets perform well, or for a QE-free world in which risky assets suffer? For the Fed, the ideal scenario might be one where they succeed in keeping the tapering threat alive without actually going there, thereby avoiding both of the above risks. For investors, the resulting low activity and low volatility environment might be challenging.
For the dollar, the future of QE seems crucial. A clean exit sometime next year would be a major positive driver and this is what investors generally appear to position for, or at least believe in. However, the danger may be that these hopes will continue to be disappointed by a risk-averse Fed, which could thus extend the dollar's underperformance for quite some time.