The pall of gloom that had shrouded global financial markets over the last few months lifted a tad last fortnight. Markets cheered statements made by the Federal Reserve Chairman Ben Bernanke suggesting that more monetary easing was still on its policy menu. The focus over the last fortnight was on Bernanke’s speech at a conference held at Jackson Hole in the US on August 26, 2011 as investors tried to gauge the Fed chairman’s assessment of the economy and his policy prescriptions. Markets had been fretting over whether the US central bank remained willing to pick up the slack left by the impasse over fiscal policy that threatens to persist. Bernanke seemed willing to play ball. While he emphasised the need to get America’s fiscal act together, he did not rule out the possibility of more monetary easing.
However, unlike last year’s speech at the Jackson Hole conference where he laid out the contours of the second round of quantitative easing (QE2), Bernanke was a little more restrained this time. For one thing, he did not explicitly mention QE3. Neither did he lay out a timetable of what specific steps the Fed would take in bringing about liquidity expansion. All he said was that “the Fed is prepared to employ its tools as appropriate to promote a stronger economic recovery in context of price stability”. However, for the financial markets, battered by the flow of adverse data and peeved by the lack of even minimal consensus on the course of US fiscal policy, even this fuzzy commitment was good enough. Besides, the minutes of the Federal Open Market Committee (FOMC) meeting held on August 9 and released on the 30th kept the market mood upbeat. The minutes showed that the Fed was actively considering more monetary measures and the degree of opposition to easing from the inflation hawks within the Fed was far more muted.
When do we expect the next round of heavy-duty monetary easing? One key difference between the macro-environment last year and now is the threat of rising inflation. Last year, deflation was the critical risk and made a strong case for quantitative easing. Inflation has queered the pitch. Thus, it’s unlikely that the Fed will inject large doses of dollar liquidity into the system when “core” consumer price inflation is close to the Fed’s tolerance threshold of two per cent. If the Fed is interested in resurrecting quantitative easing, the likely date for QE3 is early 2012 once inflation pressures subside in response to subdued economic growth. Remember that Japan’s attempt to ease fiscal stimulus in 1997, less than halfway through its recession, resulted in five quarters of negative growth and triggered a deflationary spiral. The US might meet the same fate as it withdraws fiscal support.
However, while QE3 might take some time to come, the Fed could introduce a series of measures to assure the market that it is doing all that it can to revive the economy. One measure that appears to be on the cards is referred as “operation twist” or OT (how central bankers love jargon and acronyms) that was introduced for the first time in the 1960s. This involves the Fed selling short-term securities but purchasing long-term treasury securities. Such a measure would alter the composition of the balance sheet, and flatten the yield curve by lowering long-term yields and raising short-term yields. It would at the same time ensure that the size of the Fed’s balance sheet remains constant and, thus, technically not lead to monetary expansion.
Our reading is that OT is unlikely to have much of an impact on the real economy as US long-term yields are already at a record low but have not done much to revive leveraged spending. However, the medium might just be the message. OT would be yet another reiteration of the Fed’s commitment to monetary accommodation and could help revive risk appetite in the markets. The other measure that the Fed could announce is a cut in the interest on excess reserves from 0.25 per cent to zero per cent to encourage banks to increase lending. This again might not have a dramatic impact on actual credit creation with companies and households still in the process of repairing balance sheets and paying down debt.
However, the Federal Reserve will not be the sole Western central bank injecting liquidity. The EU crisis is far from resolved since concerns have shifted from the periphery to some of the bigger regions such as Spain, Italy and even France. Besides, the Euro seems grossly overvalued, especially when it is measured by the Real Effective Exchange of the peripheral economies. Thus, from both perspectives of providing liquidity support and the imperative of getting the Euro to depreciate, large-scale liquidity infusion might be the only way out. The European Central Bank might be forced to step up its own asset purchases programme and leave the purchases unsterilised before the US does.
The writers are with HDFC Bank.
These views are personal
