Kristina Hooper, CFP®, CAIA, CIMA®, ChFC® is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
The hawks are circling but the doves still rule the roost.
Despite growing sentiment at the Fed that its asset-purchase program should be unwound, it seems unlikely it will change any time soon. But the market showed its disdain for any such tapering of asset purchases last week. It was yet another sign markets and monetary policy are highly correlated.
Indeed, it was a big week for the Fed and investors: The FOMC minutes were released and Fed Chairman Ben Bernanke testified before Congress. Investors focused on the possibility of the Fed's asset purchases slowing down in the near term, which shook markets. Not only did the S&P 500 Index fall, but also the 10-year Treasury yield moved above 2%.
The minutes suggest that FOMC members have increasingly divergent views on quantitative easing. Some members said that it has produced "positive results for the economy" and even pointed to the Bank of Japan's recent monetary policy shift as further proof of QE's stimulative impact. Other members are growing more concerned about the risks of creating future financial imbalances and higher inflation.
Despite the fact the Fed remains committed to its highly accommodative stance, investors reacted negatively to the committee's debate. That's because there's growing sentiment among some Fed members that the asset purchase plan needs to be curtailed: A number of participants suggested scaling back purchases as early as June if the economy shows evidence of "sufficiently strong and sustained growth." The notion of a proposed paring of asset purchases rattled investors. While the committee ultimately concluded that it was "prepared to increase or reduce the pace of its purchases" to adjust to changes in the outlook for employment or inflation, the timing of its eventual exit was left unresolved.
Even the Japanese are worried about the Fed pulling away stimulus soon. Thursday's sell-off in the Nikkei was at least partly due to those concerns. But it doesn't seem like the Fed is ready to taper off its asset-purchase plan. In testimony last Wednesday, Bernanke seemed to assure the Joint Economic Committee of Congress that the Fed is unlikely to slow its stimulus program any time soon, as it could threaten the economic recovery: "A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further."
It's clear that a number of FOMC members are worried about the negative impact that taking away the punch bowl sooner will have on the somewhat fragile—definitely uneven—economic recovery, especially given the headwinds of sequestration. Some members view the sequester and tax hikes as constraints to aggregate demand, although to varying degrees.
Perhaps more telling was a recent speech by New York Federal Reserve Bank President William Dudley, which detailed the history of Japan's monetary policy over the past two decades and observed that, "Fiscal policy…reversed abruptly on several occasions before economic recovery was firmly established." Japan's struggle is a lesson not lost on US central bankers, who are clearly more focused on ensuring a sustainable recovery than they are on controlling inflation, particularly since inflation appears to be a waning concern.
In fact, Dudley drew an analogy between Japan's attempts to stimulate its economy more than a decade ago and America's recent efforts: "Our policies also had a ‘start-stop' aspect to them that may have undercut their effectiveness. For example, until September 2012, our large-scale asset programs generally specified the total size of the program, with a purchase rate and an expected ending date. This created a void when the programs ended and made our policy response sporadic and hard to forecast. This limited the scope for market prices to adjust in anticipation of our future actions in ways that would help stabilize the economy."
Bernanke is focused on providing as much transparency as possible, but that much transparency also causes confusion as to what actions the Fed will take. So despite a growing chorus of FOMC members interested in reducing asset purchases sooner rather than later, they may be outnumbered by the doves—like Bernanke, Yellen and Dudley—who are unlikely to permit a tapering of asset purchases until they're convinced the economy is in full-on recovery mode.
For their part, investors should be less concerned about a near-term reduction in asset purchases. Rather, they should be prepared for the volatility that could be created by confusion over the Fed's strategy.
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