What was most intriguing about the market reaction to the recent announcement of a $US600 billion ($600bn) injection of cash into the US economy, was the timing.
The key trigger for the market’s change of heart was an article in the Washington Post in which the Fed chairman dropped a clear hint that future levels of quantitative easing will be determined not just by the state of the economy, but by the level of the stock market.
This is the so-called “Bernanke Put” whereby investors believe that if worst comes to worst, the Fed’s helicopter will simply drop a load more newly printed dollar bills to bail them out.
The Fed’s decision to unleash a new round of quantitative easing, dubbed QE2, is intended to fan the embers of the US’s faltering recovery. Its plan is to drive up bond prices by drip-feeding $75bn a month into the bond market, buying Treasury bonds with maturities of around ten years. This will reduce interest rates (yields) in the wider market, which should filter through to businesses and households as cheaper credit.
“I think that QE2 will probably work exactly as the Fed intends”
I think what the Fed is doing is fraught with danger in the long run but in the short-term it would be madness to stand in front of the monetary juggernaut. It is human nature after the kind of collapse we saw two years ago to get out as soon as you are above water again. But I think this would be premature because, for two main reasons, QE2 is likely to be a lot more effective than the sceptics suggest.
The first is that other banks will most likely follow the Fed’s lead in order to prevent their own currencies from appreciating against a weakening dollar. Japan will not tolerate a much stronger yen and the UK will probably follow suit early next year as the spending cuts and VAT hike begin to bite. This means developed world interest rates will stay lower for much longer than expected.
The second reason is that QE really will encourage spending. Credit Suisse calculates that a 1-percentage-point reduction in real bond yields pushes up asset prices by 20pc, which in turn increases the propensity to spend of consumers who see their net wealth increase. It also lowers the opportunity cost of consumption for the richest fifth of citizens who save a third of their income and account for 40pc of all spending.
Meanwhile, rising asset prices raise the collateral against existing loans, which encourages banks to provide more credit.
So, I think that QE2 will probably work exactly as the Fed intends. What is more of a concern is the consequences of firing up the printing press that are either unintended or simply a matter of indifference to the Americans. The danger of the Fed’s single-minded attention to solving the US’s economic problems is that others will inevitably be caught in the crossfire.
For example, economies with currencies pegged to the dollar (such as China and Hong Kong) are obliged to maintain a monetary policy that is wholly inappropriate in light of their strong growth. It is a re-run of the boom times in Europe’s periphery, when a cost of money that was appropriate for Germany was imposed on other countries in the Eurozone for which it patently was not. Secondly, much of the new money will simply leak into booming emerging markets. This will not end well.
But there is a difference between knowing that a situation is unsustainable and thinking that it will change anytime soon. It is far too early, in my opinion, to be talking about bubbles in many of the markets that will benefit from America’s easy money export policy.
Talk of irrational exuberance began in the middle of the 1990s, years before the stock market bubble finally burst. As long as economic recovery continues, valuations remain reasonable and inflation does not begin to spin out of control, it would be wrong to hop off Ben Bernanke’s reflation express. Don’t fight the Fed.
Tom Stevenson is an investment commentator with Fidelity International
