Federal Reserve Chairman Ben S. Bernanke has a choice: Sacrifice stimulus by trimming bond purchases or risk market distortion by further expanding the Fed’s $3.5 trillion balance sheet. Last week’s payrolls report gives him cover to cut.
That doesn’t make Bernanke’s decision any easier: Economic growth and inflation remain short of the Fed’s expectations, which might argue for keeping up bond purchases at an $85 billion-a-month clip. On the other hand, dialing back quantitative easing, or QE, would signal to investors that they don’t need to reach for yield by piling into risky securities.
“There is nothing on the economy side to have precipitated such a seismic shift in their approach to QE,” said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut, and a former researcher at the Richmond Fed.
“They are finally starting to grasp what the signal from QE has done to the markets,” Stanley said. “QE was contributing to a market environment where people were taking too much risk. The beginning of tapering in September is a lot more predetermined than the Fed is letting on.”
In a June 19 press conference following two days of meetings by the policy-making Federal Open Market Committee, Bernanke said the central bank may start scaling back its bond-buying program this year and end it in mid-2014 if the economy achieves the Fed’s growth objectives.
Fed Governor Jeremy Stein, who has backed record stimulus, went a step further in a speech the following week by signaling the central bank could start reducing purchases as early as September. He suggested enough progress has already been made to justify tapering QE by then. Rather than putting too much emphasis on the most recent economic data to determine when to cut back, officials should instead evaluate the cumulative evidence of improving economic fundamentals since the program began last September, he said.
Employers added 195,000 workers for a second straight month in June and the unemployment rate held at 7.6 percent, close to a four-year low, according to figures from the Labor Department published on July 5. The Standard & Poor’s 500 Index rose 1 percent July 5 and extended the gains in today’s trading, climbing 0.5 percent to 1,640.10 as of 11:50 a.m. in New York.
European stocks were higher, even amid signs of a weakening recovery. German industrial production fell 1 percent in May, more than economists predicted, figures from the Economy Ministry in Berlin indicated today.
The U.S. jobless rate last month compares with 8.1 percent in August 2012, the most recent figure available to Fed policy makers when they announced on Sept. 13 that they were expanding the central bank’s holdings of long-term securities with open-ended monthly purchases of $40 billion of mortgage debt in a third round of QE.
While the latest figures on the labor market may show the substantial improvement that officials wanted to see before trimming bond purchases, other aspects of the economy aren’t as rosy.
Gross domestic product advanced 1.6 percent in the 12 months through March, the weakest pace of growth since mid-2011 and down from 2.1 percent for the year ended June 2012.
Inflation has also been retreating, putting policy makers on guard to prevent a disinflationary slump. The price gauge tracked by Fed policy makers rose 1 percent in the year ended May. That’s well short of officials’ 2 percent goal and down from a 1.3 percent gain in the 12 months through July 2012, the most recent figures available to central bankers when they announced QE3.
Bernanke said during last month’s press conference that the end of purchases in the middle of next year will probably coincide with a jobless rate of around 7 percent. The FOMC has said it will consider raising its benchmark interest rate from near zero when unemployment falls to 6.5 percent.
Making the unemployment rate the “dominant factor” in determining the course of monetary policy has made it easier for officials to make the case for taking the foot off the accelerator, said Michael Gapen, a senior U.S. economist for Barclays Plc in New York and a former economist in the Fed’s Division of Monetary Affairs.
For the markets, “in the near term, that means there will probably be less volatility on any data point that is not related to unemployment,” said Gapen, who forecasts the Fed will begin to reduce bond purchases following the FOMC’s September meeting and end them by March 2014.
The first sign from Bernanke that policy makers were contemplating an exit sent bond markets reeling. In testimony before the Joint Economic Committee on May 22, the chairman said the Fed could “take a step down in our pace of purchases” in the “next few meetings” as long as the Fed is confident gains in the economy can be sustained.
Bernanke also told the committee that policy makers are “paying close attention” to the impact QE may have on asset prices. “If a frothy asset price were to reverse, what implications would that have for the broader economy?” Bernanke said. “We have greatly increased our monitoring and our attention to these issues.”
The yield on the benchmark 10-year note jumped to 2.49 percent on the last trading day of June from 1.67 percent at the end of April, marking the biggest two-month increase since July-August 2003. On July 5, after the payrolls report, the yield climbed as high as 2.72 percent, the highest since August 2011.
The low Treasury yields that preceded the recent surge had prompted investors to seek better returns in riskier assets, which in turn drove down yields on speculative-grade bonds.
The extra yield investors demand to hold speculative-grade bonds rather than Treasuries fell as low as 4.23 percentage points on May 10, the least since October 2007, according to the Bank of America Merrill Lynch U.S. High Yield Index. It reached a record high 21.82 percentage points in December 2008 as the economy slumped deeper into the recession following the collapse of Lehman Brothers Holdings Inc. On July 5, the difference was 5.04 percentage points.
“If they were truly data dependent, Bernanke should have been talking about increasing or extending QE, not about getting out,” said Jim Bianco, president of Bianco Research LLC in Chicago. “It’s no longer just about the economy, now it’s also about the markets. QE is distorting markets, and when you distort markets, things end badly.”
Not everyone agrees that the concern investors are taking on excessive risk in search of yield should be a primary consideration.
“There is some of that sentiment on the committee,” said former Fed Vice Chairman Alan Blinder, now a professor at Princeton University in New Jersey. “I don’t know there is much of that sentiment in Bernanke himself.”
Even so, the economic case for continued stimulus is becoming less compelling, based on Bernanke’s own data.
In a speech last August at the annual gathering of policy makers in Jackson Hole, Wyoming, Bernanke cited research showing the $600 billion in the second round of large-scale asset purchases that ended in mid-2011 lowered the yield on the 10-year note by an additional 0.15 percentage point to 0.45 percentage point.
If the central bank tapers monthly purchases to $65 billion in the last three months of this year from the current $85 billion, there would be $60 billion less of total QE. By the yardstick Bernanke cited, that would mean only a 0.01 to 0.04 percentage point difference in yields.
Michael Woodford, a professor of political economics at Columbia University in New York, whose paper at last year’s Jackson Hole conference foreshadowed the Fed’s decision to make its interest-rate policy contingent on economic conditions, says it’s also important to let investors know there is a limit to how long bond purchases will go.
“You have to start telling people that as the balance sheet gets bigger, the bar to justify additional purchases does start getting higher,” said Woodford. “They’re realizing they have to introduce that into the discussion, although it’s been awkward to bring it up when you didn’t frame things in that way in the beginning.”