Communications from central banks often involve ‘constructive ambiguity’ — and the US Fed is no exception .
However, the Fed’s constructive ambiguity can be misinterpreted by market players. Their reactions can then be destabilising to countries and currencies in an interconnected world.
The markets’ reactions in the past one month to Fed Chairman Ben Bernanke’s remarks that the Fed may taper its asset purchase programme if economic conditions improve rapidly, is a case in point.
Markets, in general, and bond markets in particular, reacted sharply by withdrawing funds from India, after Bernanke hinted at an early tapering of its bond purchase programme, in his May 22 testimony to the Congress. FIIs have pulled out $3.7 billion from the debt market in June 2013.
Some commentators have termed the reaction to Bernanke’s statement a bearish blunder. Have the markets overreacted?
Caveats to Tapering
It is worth noting that neither Bernanke nor the press releases issued after the last two FOMC (Fed Open Market Committee) meetings on June 19 and May 1 have mentioned the issue of a possible ‘tapering’.
The word ‘tapering’ came up in a particular context, and to a hypothetical question. The context was Bernanke responding to questions on May 22 from Kevin Brady, the Texas Republican who chairs the Joint Economic Committee in Congress.
Brady’s query was about the exit strategy from asset purchases as growth revives. Bernanke responded, “If we see continued improvement, and we have confidence that that is going to be sustained, in the next few meetings we could take a step down in our pace of purchases.”
Markets inferred from this statement of Bernanke that the Fed for sure was soon going to scale back its purchase of long-term financial assets such as Treasury bonds and mortgage securities/agency mortgage debt. Market players ignored the caveats.
Data-Dependent
The Fed has been purchasing $40 billion in agency mortgage backed securities and $45 billion of treasury securities every month since September 2012 to support economic recovery.
While QE-1 and QE-2 pursued through December 2008 to June 2011 led to asset purchase by the Fed worth $2.3 trillion, QE-III launched in September 2012 is open ended. As QE-3 is open ended, the market is left guessing about how long it will continue. Asset purchase by the Fed is an unorthodox policy instrument and was undertaken to promote the outlook on the labour market.
Given the market’s reaction to his statement on May 22, Bernanke laboured hard to respond to a host of queries after the FOMC meeting on June 19. The crux of Bernanke’s message was that the course of policy is data-dependent and that markets can see the data and form their judgment on the timing and pace of asset purchases.
Macro Picture Projection
Hence, the possible trajectory of major macro variables in the coming quarters is a crucial area. The macro variables for the US economy in Q1 of 2013 are: GDP growth of 1.8 per cent, unemployment at 7.6 per cent and consumer price inflation of 1.4 per cent.
The FOMC’s assessment of the US economy in its June 19, 2013 meeting is that growth will pick up moderately over the next several quarters, accompanied by improvements in the unemployment situation, as near-term restraint from fiscal policy and other headwinds diminish.
The Fed pins its hope of growth revival on improvements in the mortgage market observed in the recent past.
The Fed also expects that inflation will creep to 2 per cent over time. The central tendency arising from 38 expert projections are: 2.3-2.6 per cent growth for 2013 rising to 2.9-3.6 per cent in 2015, unemployment rate of 7.2-7.3 per cent in the fourth quarter of 2013 falling to 5.8-6.2 per cent in the final quarter of 2015 and an inflation rate of 0.8-1.2 per cent for 2013, creeping to 1.6-2 per cent in 2015. The Fed has indicated that it will moderate the bond purchase later this year if these expectations materialise.
Reduction Path
The reduction in monthly bond purchases would commence in the later part of 2013 and continue through the first half of 2014 in moderate steps and will end towards mid 2014.
Bernanke feels that the unemployment rate should reach 7 per cent when the monthly bond purchase programme comes to a halt, from 8.1 per cent when the programme was started.
The pace of reduction in asset purchases is entirely dependent on how macroeconomic conditions evolve. Since labour market conditions are crucial for the pace of increase or decrease in asset purchase, it is worth noting that the natural rate of unemployment for US is 5-6 per cent.
The present unemployment rate of 7.6 per cent is much above the natural rate. Besides, the problems in the labour market are complicated by under-employment and long-term unemployment. If growth prospects in US actually improve significantly — the necessary precondition for the Fed scaling down the purchase of assets — it should be a matter of cheer than despair.
As Bernanke has reiterated in his testimony before the Congress that monetary support is crucial to the US recovery, market players should be paying close attention to the evolution of macro parameters in the US rather than jump to half-baked inferences.
The author is Acting Dean, Xavier Institute of Management, Bhubaneswar. Views expressed are personal.