In recent years the world’s major central banks have been highly accommodative – keeping interest rates hard to the floor and expanding their balance sheets. Now the Federal Reserve finally looks to have found a reverse gear as it readies a “tapering” policy to unwind quantitative easing (QE) and years of financial asset purchases.
Across the pond in Asia, the actions of the Fed are being keenly watched, given QE was responsible for lifting a range of currencies and asset markets. Already the mere anticipation of tapering has sent various Asian and other emerging market currencies into a tailspin as global fund flows reverse.
To get a sense of what a reversal of QE might mean, we sat down with CME Group Chief Economist and OpenMarkets contributor Blu Putnam.
How much clarity do we have on Fed policy and the likely impact of tapering?
We should get considerably more clarity on 18 September when the Federal Open Market Committee (FOMC), meets. For now, there is only a consensus among market participants that an important announcement about QE tapering plans will be made.
Even as the Fed readies itself to taper its asset purchases, the Fed seems intent on making sure the market knows it could increase or decrease purchases in the months ahead, depending on how the data evolves, especially employment data.
The Fed has also been clear that its target federal funds rate will stay near zero through the QE exit process and for an extended period beyond. This means monetary policy will remain highly accommodative until inflation pressures take a firm grip, and there is virtually no inflation pressure in the U.S. right now.
There also appears the possibility that the Fed might differentiate the pace of tapering depending on the asset. That is, under the current program, the Fed purchases $40 billion of mortgage-backed securities each month and $45 billion of U.S. Treasury securities. Of the Treasury purchases, about 25 percent are of 10-year maturities or longer. In terms of the actual impact on yields in the Treasury market, it is the buying of the long-dated maturities that matters far more than the other purchases.
One scenario suggests that the Fed is slowly becoming much more aware of the strength of the labor markets and relative fragility of the U.S. housing recovery. House prices have been rising, but there are concerns in the market over the credit process. Many home sales are for cash or have very large down payments. Only the most creditworthy of borrowers can even get a loan.
And, the U.S. Government wants to shrink the mortgage agencies, Fannie Mae and Freddie Mac. The Fed’s buying of mortgages has little impact on their rates, as mortgage pricing is based on longer-dated Treasury yields. But the Fed’s buying of mortgages does add liquidity to the mortgage market. Consequently, the Fed may choose to reduce its purchases of Treasuries much faster than its mortgage purchases.
When so many central banks are now deploying quantitative easing-type policies, do we need a new toolkit for currency forecasting?
What we are seeing increasingly is that currency values in the major economies are being driven by political considerations and policy shifts rather than traditional economic fundamentals.
Even with a Fed exit from QE, the U.S., Europe, and Japan will all still have near-zero short-term rates, economies performing below longer-term trends, and no inflation pressures. So essentially, the U.S. dollar, Euro , and Japanese yen all have the characteristics of weak currencies. But when it comes to exchange rates, however, everything is relative. If the euro and yen were not fundamentally even weaker, this would be bad news for the U.S. dollar. As it is, the U.S. dollar gets top billing by default.
In the short-term, we are left to watch the ebbs and flows of the political decision process. In the longer-term, we are monitoring inflation pressure. The question is which countries are likely to see material inflation pressures emerge first? And would that inflation pressure prompt central bank action on raising rates?
Milton Friedman was famous for noting that there were long and variable lags between monetary stimulation and inflation. Any major country that considers raising rates is likely to get a strong currency, but for now, no one is contemplating the possibility of raising rates at all.
What do you make of the current situation in Japan where policy is seeking to achieve 2 percent inflation?
The last time Japan had inflation readings above 2 percent was during the July – September 2008 period, just before the global financial crisis and recession that brought a return of deflation. Currently, Japanese consumer prices are all of 0.7 percent (July 2013 data) above their level of one year ago, and most of this rise has been due to rising energy costs. Core inflation, excluding food and energy is at -0.1 percent compared with one year ago.
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If we see inflation pressures emerging, expect Prime Minister Abe and his team, including the Bank of Japan, to be cheering prices higher. Our base case scenario is that the core inflation data will post a 1 percent increase with the data for January 2014 (to be released at the end of February 2014). We do not see a trend for inflation to move any higher than this, however, unless the yen goes through another period of weakness, and this is not so clear.
The next big issue for Japan is the decision on whether to allow the national sales tax to rise from 5 percent to 8 percent, effective in April 2014. Signs point to the probability that Prime Minister Abe will allow the tax hike. Our view is that this major sales tax increase will cause a considerable increase in consumption spending in the January – March 2014 quarter, ahead of the tax increase. Unfortunately, we see declines in real GDP for several quarters after the higher tax goes into effect. Inflation data, adjusted for the sales tax rise, may even decline again, and the Prime Minister will have to decide if more stimulus is needed to keep his economic program on track.
If QE moved Asian currencies on the way up, should we expect the Fed’s tapering retreat also to have a significant impact in Asia?
One of the initial consequences of central bank asset purchases was to remove some risk from markets. This worked in favor of riskier assets, including emerging market currencies. So the removal of QE in the U.S. is reflected in a return to higher and more normal volatility. The higher volatility has resulted in some market participants reducing their exposures to riskier assets, including emerging market currencies.
Unfortunately for emerging economies, the debate over the Fed’s QE exit plan has also coincided with a number of other unrelated factors that have raised perceptions in world markets about political risks. Whether it is demonstrations in Brazil about economic progress, in Turkey about development plans, in Egypt about political freedom, or the ramifications of the civil war in Syria, there is a lot to worry about in terms of political risk. Again, the market response is to reduce exposures to all of the higher risk assets, and this has included Asian and Latin American currencies.
For the most part, most countries have opted for small rate increases and avoided FX intervention, Brazil excepted. As currency values have fallen to lower levels, many of these currencies will again look attractive if there is a respite in geo-political risks.
And what about the potential impact on China as it pushes ahead with financial liberalization reform?
China has chosen a different currency path where it uses foreign reserve accumulation as its primary monetary tool. In recent years it has accumulated several trillion dollars of U.S. foreign reserves to keep the yuan stable. Due to its capital controls, China should in theory be less exposed to Fed tapering. China, though, has its own transition in progress from an infrastructure spending model that is no longer sustainable to a domestic demand growth model.
To allow domestic demand to grow faster, China is considering more flexibility in its monetary policy and developing its money markets at a faster pace. This also implies benefits to China from greater integration with world markets, in terms of supporting domestic demand growth.