Posted On Thursday, Jan 09, 2014
The wait is finally over, the Fed turns the clock with the decision to taper the monetary infusion; albeit by a token amount of $10 bn as earlier expected. The Federal Reserve will pump a little less money into the U.S. economy in January, marking the beginning of a long and perilous journey back to a more normal policy setting. It’s important to understand that the Fed is not hitting the brakes, rather just easing up a small amount on the gas pedal.
The Taper uncertainty
At the behest, as the uncertainty concerning the debt ceiling and nomination of Fed chair seemed to wane, the tapering was due. The Fed seems to have caved into market pressure to reduce the monetary extravaganza. Tapering in a more real sense would have involved giving an end point for when they will stop increasing the balance sheet.
Currently, the consensus estimate is that the Fed will continue to reduce the size of its QE program through 2014 and ultimately wind it up by the end of the year. However, this isn`t necessarily a guarantee given that a) the program is data-dependant and b) both the Fed chairmanship and the several board positions will change early next year. As a result, both the timing and extent of the QE withdrawal remains uncertain.
In its endeavor to roll back QE, the Fed needs to strike a careful economic trade off. It needs to transform the growth trajectory from being policy-induced to a more sustainable private sector investment cycle-led impetus. This requires much higher levels of business and consumer confidence and a more distinct policy framework.
The real impact
The Fed has been seeking a measure of inflation for five years now without success. Also, that economic growth has disappointed despite such aggressive stimulus suggests that monetary policy is not working very well. If the Fed were to suddenly suspend QE3, it is doubtful whether the real side of the economy mainly concerning spending, production and employment would show much impact. Beyond a point, the asset markets could start feeling the pinch of withdrawal.
True State of the Economy
At the first glance, the Fed’s decision to slow down bond-buying, starting with a $10 billion reduction in January, is a sign of confidence that the economy is starting to stand on its own two feet. But a closer look at the underlying economy indicates a very weak labor market – the most important indicator of the health of an economy.
Although, the unemployment rate has fallen from its peak of 10.0 percent in 2009 to 7 percent in 2013, this seems to be mostly because people have given up looking for work. The labour participation rate stands at 63% - a multi decade low. The employment to population ratio is just 0.4 percentage points above its low for the downturn suggesting no real improvement as suggested by the unemployment rate. It is still more than 4.0 full percentage points below pre-recession levels, corresponding to 9.5 million fewer people with jobs.
And this is not a story of retiring baby boomers. Employment among people aged 25-54 is down by 4.0 percentage points from its pre-recession level. Furthermore, the weakness of the labour market drags down large segments of the workforce as many workers find it impossible to get wage increases when the labour market is so weak. The number of people living on food stamp assistance is at record highs testifying a weak labour market.
Policy – the way forward and potential pitfalls
It remains an undisputed fact that debt levels across major economies still remain unsustainable. Central banks are making it easier to carry this debt overload by keeping interest rates at record-low levels. But lowering the financing costs is only a partial and temporary solution because the absolute condition of balance sheets matter and we should not be surprised that this is a factor weighing on consumer and business confidence. People are smart enough to know that high government debt levels mean higher taxes and/or reduced services down the road.
There is a good chance the unemployment threshold for the Fed to begin thinking about rate hikes will be lowered from 6.5% to 6% as the decline in participation rate would suggest. And that means zero rates could be with us until well beyond 2015 if the economy shows fewer signs of improvement.
Once the cash injections end for the Fed then their insistence that rates will remain low for a long period of time until the economy recovers is what is likely to keep markets under check. However, the real test is whether they will be believed by markets who determine the rate at which they will lend to the government over the longer term. When a central bank holds interest rates below their natural market level, it stands there to provide however much liquidity is required to keep the rate suppressed. QE is one form of this liquidity, and the extent to which QE is reduced must be compensated for by other means if interest rates are going to be kept at the target level.
After all, in line with Fed’s endeavor there is a growing belief that inflation will take off given the vast amounts of money infused in the economy. If so, then market participants are unlikely to lend money at a low nominal interest rate since their real return is the difference between the nominal rate and inflation down the line.
Gold – the reaction and way forward
With the Fed beginning the end of their bond buying, and inflation numbers remaining well below targets the precious metals simply have fallen out of favor with many investors. Markets have been busy running ahead speculating on their expectations not just with gold but other asset markets akin. Government bond yields, particularly for the weaker eurozone states do not reflect credit risk. Equity markets are priced on the back of zero rates as far as the eye can see. Even credit is being extended on the back of the assumption of a prolonged period of zero rates. The important point is not tapering, but a hazardous assumption of zero rates.
It’s going to be extremely complicated task of juggling market expectations to perfection. All those stashing gold, linking it just with unwinding of QE are effectively pushing a one-sided argument and ignoring the moral hazards of cheap money policy and have tended to forget the Greenspan era.
Some of the tail risks facing the global economy may have diminished, but many structural problems remain. There still exist serious imbalances and problems in many countries, including excessive private and/or public debt, the unsustainable divergence between record corporate profits and steadily declining wages, rising inequality, and mispricing of asset markets at best. It is futile to think that easy money and higher asset prices can really be a solution to current economic problems. We are in a phase of experimental central banking, which is likely to end badly due to the dislocations of capital it has caused through prolonged periods of negative rates.
The explosive growth in central bank balance sheets can result into unpleasant long-run consequences of generating high inflation and can derail financial stability. Policymakers who got us into this mess are unlikely to navigate us out of it as exit processes lack a clear road map and therefore could be indeed confusing for the current state of highly sensitive markets. The unintended consequences of such unconventional polices on asset markets would probably be felt at the time of unwinding.
Year end positioning by investors looking to book losses to offset big gains in the equity markets could add additional selling pressure on the precious metals as we move into the last trading week of 2013. Meanwhile, if the global economy is indeed trapped in a subpar growth environment then it will likely translate into central bankers getting further aggressive in building ever-greater balance sheets with ever-greater negative consequences down the road.
Investors would do well to remember that gold is one of the good portfolio diversification tool and thereby may be helping you to reduce overall portfolio risk.
Data Source: Bloomberg, World Gold Council
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