Given repeated Fed policy shifts in recent months, it is useful
to step back and review the changes and consider their significance
in perspective in terms of future impact on the US and global
economy. The following article suggests elasticities between
financial asset prices and Fed QE policy are becoming more unstable
-- i.e., more elastic -- while more inelastic between Fed policy
and real investment. As the Fed continues its "stop-go" approach to
reducing QE3 liquidity injections, markets are becoming
increasingly sensitive to each attempt in terms of timing, rate of
change, and magnitude of response to the Fed's shifting QE
intentions. Fed forward guidance policy in turn is becoming less
effective, and monetary policy instability is potentially rising.
Is the Fed slowly losing control of monetary policy as a
consequence of repeated "stop-go" intentions with regard to QE?
What are the consequences for emerging market economic growth,
financial asset price volatility, and the US economic recovery?
A week ago, the US central bank, the Federal Reserve (Fed),
opted not to change its current 3rd Quantitative Easing (QE) policy
providing $85 billion a month in bond purchases from bankers and
investors. The Fed's QE3 policy has been in effect for about a
year, injecting thus far approximately $1 trillion into the US and
global economy. Since QEs began in 2009, at the current QE3 rate
the total injection will have exceeded $4 trillion by the end of
Consensus was strong in early September 2013 that the Fed would
at least slightly reduce that $85 billion by a token $5-$10 billion
a month. That would have provided a mild, second signal it would
begin reducing its $85 billion a month money injection.
Last May 2013, the Fed's chairman, Ben Bernanke, signaled for
the first time to markets the Fed might soon start "reducing" QE.
That set off what has been called the
by investors. Almost immediately in response to the Fed's
suggestion, rates on bonds began to escalate, including mortgage
rates, corporate and US Treasury bonds -- all of which surged by
more than a full 1% in a matter of weeks.
The outcome was that the tepid US housing market recovery almost
stalled, stock and bond prices began to tank, and investment into
"emerging markets" -- where much of the total $4 trillion in QEs
since 2009 has gone -- began to reverse and flow back from abroad
to the US and Europe. Emerging markets' currencies in turn began to
decline, the global currency war ratcheted up another notch, and
capital flight from those economies to the west accelerated.
Faced with the
the Fed quickly shifted its policy signal in early July once again,
reassuring investors that a significant retraction of QE3's $85
billion wasn't really their intention. Financial asset prices rose
Then, as part of its "forward guidance" policy, the Fed in
August, tried to extricate from its QE3 program a second time, this
time more cautiously than it did in May, signaling it might reduce
its monthly QE3 policy at its upcoming mid-September 2013
Extrication from QE3 has become increasingly necessary. Fed
policies are becoming increasingly "inefficient" -- that is, while
feeding financial asset bubbles they are yielding decreasing
increments in real investment in goods and services. As QE
continues and financial asset market prices rise, a number of
recent reports show the growth of gross private domestic investment
long term continues to slow. According to one recent report on the
UK economy, only 15% of financial flows since 2009 are now going
into real investment in goods and services. Other analyses in the
US reflect the same trend.
The Fed's second "forward guidance" in August of its prospect of
tapering in September led in the case of emerging markets to
renewed capital flight, currency declines, rising interest rates
and slowing economic growth.
At the same time, by late summer in the US, a number of economic
indicators began to show that the US economic recovery is not as
strong as the press hype has been suggesting. Moreover, the Fed
lowered its own forecast for the US economy, from 2.5% earlier in
2013 down, most recently, to 2% GDP growth. (That downward revised
forecast was not the first. In fact, the Fed has consistently
reduced its US economic forecasts for the past three years, from an
originally predicted 4.3% annual GDP growth.)
Then on September 16, the Fed shook markets and investors by
deciding not to "taper" at all for the moment, suspending its
August guidance of a
of $5 or $10 billion a month.
A longer perspective on recent shifts in Fed policy since May
reveal that, in a matter of just a few months, the Fed has shifted
from responding to the "Taper Tantrum" to suggesting a "Token
Taper" to a subsequent retreat once again. Two efforts at reducing
QE that resulted in two quick retreats from the same.
Over the past week it appears a third "go" at reducing QE, as
several Fed board governors are once again suggesting a third time
that a reduction of the $85 billion will occur before year end, and
perhaps even start in October.
The retreat from the
in recent weeks has given way to the emergence of an imminent "
What all this policy shifting signifies is that in the last
several months the effectiveness of the Fed's "forward guidance"
policy is deteriorating significantly. Fed policy is entering a
period of a public crisis of confidence that could well lead to
increasing stock price volatility, and at a time that increasingly
acrimonious "debt ceiling" negotiations between Congress and the
Obama administration are beginning to intensify and suggest even
The response of financial markets -- in terms of response time,
rate of change, and magnitude of price shifts -- to the Fed's
double "stop-go" (and now "go" again) QE tapering plans illustrates
the tight positive correlation between financial asset prices and
QE that has been evident ever since QEs were first introduced four
years ago. At the same time, evidence of correlation between QEs
and real investment continues to decline.
What the Fed's "stop-go," on and off, QE policy signifies in a
broader sense is threefold:
First, that investors have become addicted to the QE, low
interest and free money policies of the Fed that have been in
effect the past five years -- as this writer predicted would occur
nearly two years ago elsewhere. The mere suggestion of a QE
retraction, even when token, results in rapid and significant
financial asset price declines and rising interest rates. A
"cold-turkey" withdrawal of QE liquidity sends markets into
tailspins that recover just as quickly when assurances of liquidity
restoration occur. However, while asset prices return to prior
levels, interest rates do not and instead drift upward.
Moreover, each time the Fed retreats on its signal to taper, it
makes the next attempt even more difficult as investors anticipate
and become even more predisposed to quickly respond to counter any
Fed suggested move. The elasticity of asset price response
increases-both in terms of timing, rate of change, and
Secondly, the Fed's recent stop-go policies suggest the real
economy has become super-sensitive to interest rate hikes-just as
it has become "super-insensitive" to interest rate reductions over
the past five years. In economists' parlance, this is expressed as
the economy having become "increasingly inelastic" to interest rate
declines -- i.e., falling rates generating little real growth --
while conversely becoming "increasingly elastic" -- rising rates
quickly slowing real growth -- to interest rate hikes.
QE is thus resulting in the real economy responding less and
less positively to money supply injections and interest rate
declines, while more and more negatively to money supply reductions
and interest rate hikes.
Thirdly, the Fed's key policy of "forward guidance" is
unraveling as a consequence. No one really knows what the Fed is
going to do now, how it plans to do it, and when and at what rate
it plans to begin doing it. In short, as it engages in repeated
"stop-go" QE reduction signals, the Fed is slowly losing control of
the monetary tools by which it has been stabilizing the banking and
financial system the past five years.
Emerging markets may react even more volatile to the next taper
iteration by the Fed, producing even more currency volatility,
capital flight, and economic slowdown. More hot money will flow
into China's increasingly fragile local property markets via its
growing "shadow" bank network there. Financial asset bubbles,
having returned in the interim, will pose an even greater risk of
too rapid asset price contraction at some later date.
In conclusion, this writer's prediction is that asset prices in
the coming months will become even more (positively)
"super-sensitive" to QE withdrawal efforts by the Fed, while the
real economy becomes more (negatively) super-sensitive to interest
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
Gold And The Dollar: One Up, One Down