After the downgrade and an extended slump in markets the Federal Reserve has acted.
By announcing that economic conditions ‘are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013’ the US central bank has effectively tied itself to no rate rises for two years.
It is not another round of Quantitative Easing - QE3 as some had hoped - but it may be the next best thing. US bond yields have fallen to record lows, equity markets have rallied and the dollar has weakened – all of which will help reflate the ailing US economy. Three cheers for Ben Bernanke as he rides to the rescue once more!
Committing to a given path of action sends a strong message to markets that the Fed will do whatever is necessary to get the economy going and keep unemployment falling. It is a move which will help address the risk of a loss of confidence by the private sector and the danger of a liquidity trap where caution drives firms and households to hoard cash rather than spend.
However, it is controversial and three members of the committee dissented, preferring to have retained the existing stance of keeping rates exceptionally low for an extended period, seen as the next two meetings rather than the next two years.
Along with commitment comes a loss of flexibility: the Fed can still tighten or loosen through changes in its balance sheet, but such moves are not as powerful as rate changes. By taking this step the Fed is virtually throwing in the towel on an economic recovery, unable to see a scenario where growth would be strong enough to warrant a rate hike.
That cannot be good for markets. Either the Fed is right and the economy struggles for the next two years with adverse pressure on earnings and the budget deficit, or it is wrong and we see activity pick up with the risk of inflation as policy is kept too loose.
Our view is that pessimism on the economy is over-done in the near term, but we recognise the medium-term risks. Markets may be pleased by the Fed’s efforts in trying to mitigate the macro tail-risks, but as we have seen, its tools are not that powerful. Growth is faltering despite rates being close to zero and two rounds of QE. The truth is that the headwind on activity from de-leveraging is powerful as balance sheet adjustment overwhelms the traditional policy transmission mechanisms.
From this perspective, the current rally in markets is largely liquidity driven as investors seek yield and push back out along the risk curve. Low rates will cause more capital to flow into gold and emerging markets. The latter will not please Beijing and others in Asia or Latin America who are grappling with excess liquidity. The overall message though is that the expiry date on the ‘Bernanke put’ is some way off.
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