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Explainer: What US Fed tapering means for markets

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The US Federal Reserve has announced that after more than five years of support, the “tapering” of its quantitative easing program is to begin. So what will the consequences of the gradual withdrawal of the program be, not only in the US but in Australia and emerging markets?

The Fed currently holds more than US$3.2 trillion in mortgage-backed securities and US treasuries, the majority of these purchased under the three consecutive open-market schemes that have formed its quantitative easing (QE) program. The goal of QE was to stimulate the economy by lowering interest rates at the medium and longer-term end of the yield curve.

While it had always been made clear that the QE programs were to be temporary, financial markets had become used to the support over the past five years. The concern in recent months that the Fed was considering scaling back this program had triggered volatility in financial markets and prompted capital outflows from emerging markets.

But, surprisingly, US share markets actually rose after yesterday’s decision – a reaction that suggests the markets viewed the announced US$10 billion decrease in monthly security purchases as moderate. The Fed will still be buying large amounts of securities, at US$75 billion a month, to be added to its already significant holdings. Markets will also have welcomed the Fed’s comment that its key interest rate would stay lower for longer than it had previously promised. The Fed said it “likely will be appropriate” to keep overnight rates near zero “well past the time” that the jobless rate falls below 6.5%, especially if inflation expectations remain below target.

In announcing the tapering, Ben Bernanke was optimistic the US would soon move out of the recovery phase and into more normal economic growth. “We’re hopeful … we’ll begin to see the whites of the eyes of the end of the recovery and the beginning of the more normal period of economic growth,” he said. He also commented that he had consulted closely on the decision with Janet Yellen, who will succeed him as chairman on January 31, and “she fully supports what we did today”. That will have reassured markets that Yellen will follow a path of gradual tapering, rather than anything they might find more challenging.

The Fed has been extremely cautious with the announcement of tapering and delayed the start. It is reasonable to expect this caution will persist and that the impact on US financial markets, institutions and instruments will be limited.

However, in the longer run the concern persists that the QE program could increase inflation, because the money supply has increased significantly. The moderate performance of the US economy has kept overall inflation low, but this situation could change quickly. The impact of the tapering on money supply will depend on both the future rate of reduction and on the maturation of the bond assets held by the Fed under the program.

In non-US markets, however, the impact of the tapering may be more severe. In particular, emerging markets such as India, Indonesia and Thailand have indirectly benefited from the QE program and may suffer from its tapering. The consequences could be exacerbated by local problems, such as political unrest in Thailand or a moderation of economic growth.

Emerging markets seemed to be taking news of the start of tapering in their stride, but it remains to be seen whether this will last. Emerging markets compete in capital flows with other countries and developed economies have strengthened recently in relative terms. In Australia, news of the tapering sent the Australian dollar down to a three-month low of US 88.2 cents, though it soon moved back above US 89 cents, where it had been before the news. Australian share markets increased in unison with US markets.

Any sustained fall in the Australian currency, as the US dollar appreciates, would be welcomed in many sectors of the economy, such as manufacturing and education, even if it is too late for Holden.

The strong dollar has long been of concern to the Reserve Bank and others because it reduces our international competitiveness. Reserve Bank governor Glenn Stevens this week cited the high currency as one of three things retarding economic growth, along with weak confidence and the lacklustre pace of economic reform. It is not surprising that Stevens also said this week that he would welcome the start to tapering, though it could have “some disruptive effects”.

Read more http://theconversation.com/explainer-what-us-fed-tapering-means-for-markets-21639

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