Is It Time for the Fed to Wind Down the Economic Stimulus?

Published: July 31, 2013

in Knowledge@Wharton


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Is it time to "taper?" That is the question du jour on Wall Street and in economic circles -- whether the Federal Reserve should start winding down the "quantitative easing" bond-buying program that has helped stimulate the economy.

Views are mixed. Several experts, say yes, it's time. Others worry it could be too soon. Three of the four experts that Knowledge@Wharton interviewed said that although economic growth is far from robust, still lingering at less than 2%, the economy has improved and appears ready to return to normal -- or perhaps a "new normal."

"I would say you would need 3% [annualized GDP growth] for tapering to begin," says Wharton finance professor Jeremy Siegel. "That's not a slam dunk, but right now that is my median forecast. I think we are going to get 3%-plus for the third and fourth quarters. That's going to lead to the tapering."

Not everyone believes, however, that the Fed needs to move this soon. "I personally am surprised that they have started to talk about it with unemployment at 7.6%, and without a stronger economy," says Wharton finance professor Krista Schwarz, who once worked on the Fed's open market desk in New York. There is a case to be made, she notes, that the Fed ended some of its earlier stimulus programs too soon. "Hopefully, this isn't them making the same mistake again."

New Fed Leadership

The issue is front and center as U.S. President Barack Obama seeks a replacement for Federal Reserve Chairman Ben Bernanke, who will step down in January, leaving the next chairman to phase out the stimulus programs, which began in 2008. In the past week, speculation has centered on two candidates, Fed Vice Chairman Janet Yellen and former Treasury Secretary Lawrence Summers. Most experts think Yellen would taper slowly, to allow the programs more time to stimulate job growth. Summers is thought to favor a faster withdrawal, as he has been less enthusiastic about the Fed's massive market intervention.

Though the Fed has engaged in a variety of efforts to shift the economy to a higher gear, the most prominent is the purchase of $85 billion a month in Treasury securities and mortgage-backed securities. This quantitative easing -- now in the third phase, known as QE III -- increased demand for those bonds, lifting their prices and driving down yields, which move in the opposite direction from prices. That has helped to reduce yields on long-term bonds of all types, and that has helped keep down interest rates on mortgages and other loans. Making it cheaper to borrow stimulates spending, helping the economy grow.

Bond buying began with QE I in late 2008, when the Fed had between $700 billion and $800 billion on its balance sheet. Now it has several times that, causing worries that Fed holdings distort the natural balance between supply and demand for these assets.

Another concern is that unusually low interest rates, while a blessing to borrowers that stimulates spending, are tough on bank savers, pension funds and investors who count on interest income. And eventually, too much stimulus can spur inflation, though that has not happened so far. So, as the economy gets healthier, stimulus programs are brought to an end and interest rates are allowed to go up.

To return to a normal market governed by natural forces of supply and demand, the Fed must stop buying bonds, then begin selling those accumulated in its inventory, a process likely to take five to 10 years, according to Wharton finance professor Joao F. Gomes.

Eventually, the central bank will also allow short-term interest rates, such as the federal funds rate, to rise. Currently near zero, that rate is normally in the range of 3% or 4%. In June, Bernanke indicated that rate could be allowed to rise if inflation remains at 2% or less and unemployment falls to 6.5% from the current 7.6%. The Fed funds rate governs short-term lending between banks.
In several statements beginning in May, Bernanke has said tapering could begin in September with a drop in monthly purchases to $65 billion, and wrap up as early as summer 2014. But he has emphasized that the schedule will depend on economic growth. And because he is leaving, the course of tapering is uncertain, causing jitters on Wall Street.

Bernanke's recent talk of tapering seems curious to Schwarz. From his earlier statements, she expected QE III to continue until unemployment had fallen further.

"From the signals they sent around a year ago, it's surprising that they're in such a hurry to cut down their asset purchases," she observes. "It borders on reneging." Clearly, she adds, inflation is not yet a threat, so there's no need to slow the economic rebound. One possible reason for the hurry, she says, is concern among some experts and politicians that the Fed's holdings have just become too large.

Those assets have been earning interest, which is passed to the Treasury, helping to reduce deficits, with about $89 billion remitted in 2012. But the QE programs also involve the Fed paying interest to financial institutions that keep huge reserves with the agency. As interest rates rise, that interest cost will grow, and wipe out the Treasury payments.

"If the interest rate does rise, then they end up not being able to pass along anything to the Treasury for a few years," Schwarz says. "That may be one of the things that have influenced their rush to end further expansion" of Fed holdings. Paying less to the Treasury should not be a concern at the Fed, she contends, because payments of this sort are not part of the Fed's mandate, merely a welcome byproduct of an extraordinary program.
U.S. economic growth has been stuck below 2% -- low enough, some economists think, to justify continuing the Fed's stimulus efforts. But Siegel and many others believe faster growth is coming. While many experts think the Fed will to start to raise the Fed funds rate in early 2015, Siegel thinks the economy will grow strongly enough to bring that move sooner.

Mark Zandi, founder of Moody's, expects tapering to begin late this year. "At that point, the economy should have navigated through the fiscal headwinds that it's in the middle of right now -- the tax increases and spending cuts -- and growth should be picking up steam. Most notably, that should show up as more job growth and lower unemployment."

Tapering is likely to finish "sometime next spring," Zandi notes, and raising of the Fed funds rate will probably begin about a year later, when unemployment has fallen to 6.5%, with the funds rate eventually going to about 4%. "We get to Nirvana sometime, probably, in 2016 or early 2017," he adds, describing a healthy economy. "It's a long road back, almost a decade."

Go Slow, Stay Flexible

All of the experts that Knowledge@Wharton interviewed say the Fed should stay flexible, and willing to slow the pace of tapering if economic growth does not accelerate fast enough. At the same time, they note, the Fed can help calm the markets by stating as clearly as possible what growth and unemployment targets must be met before bond purchases are cut to the next level. "I think it would be really helpful if the Fed lays down the conditions," Gomes says, adding: "Bernanke is in his last few months on the job, so it's unavoidable that we have some uncertainty. It's a shame."

Siegel believes the Fed's first step should be to reduce monthly bond purchases to some $65 billion to $70 billion from the current $85 billion. Further reductions would reduce purchases in $10 billion to $15 billion increments, reaching zero sometime in the spring of 2014.

Among the issues the Fed must deal with is just how to talk about tapering, as the financial markets have become sensitive to the issue. Stocks plunged by more than 4% in June after Bernanke suggested interest rates would be allowed to rise. Many investors and market experts believe the low-rate policies have helped lift stock prices by making bonds less appealing as an alternative, and by reducing corporate borrowing costs, which improves earnings. "This has been an amazing program from the point of view of stock-market investors," says Gomes. "It's been magnificent."

Siegel adds, though, that many investors give quantitative easing too big a role in stock gains. "The market is, in my opinion, way too fixated on this quantitative easing as being the cause of the increase in [stock prices], so they think that once this quantitative easing is over the market will fall back. I think that's wrong." Zandi, too, believes stocks can continue rising amid tapering. "Investors will be balancing the negative of higher interest rates against the positive of a stronger economy and stronger growth," he says. Rising interest rates are not likely to hurt stocks if corporate earnings are going up at the same time, adds Gomes. "When you put the two things together, I think it will be neutral."

Federal Reserve policies during and after the financial crisis have been controversial, with many conservatives believing the Fed tinkered too much with free markets, while many liberals think the stimulus programs should have been even more aggressive. The Fed and Bernanke, says Siegel, deserve an "A" for the range of policies, which included guaranteeing credit for the financial system, protections for certain types of assets, protecting deposits and the solvency of money market funds.

"I think quantitative easing, although it received a lot of criticism, was important in terms of speeding the U.S. recovery," Siegel says. "The fact that the U.S. and the developed world have been leading the recovery [worldwide] is due to Ben Bernanke's policies." Zandi concurs: "I think all the criticisms that have been lobbed at their extraordinary actions, including quantitative easing, have really fallen flat."

"Bernanke, and everybody at the Fed, were given a pretty tough exam," says Gomes, "and they probably got 75% or 80% right." The key, he says, was a willingness to keep trying new things, many of them untested.

That contrasts with a rigidity that until very recently has kept Japan mired in economic doldrums for more than a decade. "You have to be open minded and throw out the playbook."

Still, a few unknowns linger as the next set of policies replaces the last. Among them: Will interest rates and inflation settle into a "new normal" -- a range different from the past?

Schwarz believes the 10-year Treasury note, currently yielding about 2.7%, could settle at a new normal around 4%, a tad lower than the 4.5% generally considered normal in the past. Siegel believes yields and inflation will both be lower in the future than they were, on average, in the two or three decades before the financial crisis.

Zandi agrees. But he also expects stock gains will be more modest than they were before the financial crisis. In the latter decades of the 20th century, prices of stocks, bonds and homes were driven up by the gradual decline in interest rates, a condition that is not likely to be repeated in the near future, he notes. With the falling-rate factor removed, stock gains will rely on economic growth, which drives profit growth, leading to annual returns perhaps averaging 5% instead of 10%. "Asset returns have been quite strong -- extraordinary, really -- but those days are over."

July 31, 2013 4:18 pm

The benefits and perils of riding China’s coat-tails
Many Latin American nations have bet the mine on an economy that is now slowing
 Few parts of the world have benefited as much from China’s rise as Latin America. In 1990, China was a lowly 17th on the list of destinations for Latin American exports. By 2011, it had become the number one export market for Brazil, Chile and Peru and number two for Argentina, Cuba, Uruguay, Colombia and Venezuela. Over that time, annual trade rose from an unremarkable $8bn to an irreplaceable $230bn. Chinese leaders predict it will reach $400bn by 2017.
As China builds its colossal cities, constructs its networks of highways and railways, and feeds its evermore carnivorous people, Latin America has much of what it takes to keep the show on the road. Chilean copper, Peruvian zinc and Brazilian iron ore are being shipped in vast quantities.
The region is the Middle East of food, accounting for 40 per cent of global farming exports. It supplies water-poor China with dizzying amounts of beef, poultry, soya, corn, coffee and animal feed. If Chatinamerica rolled off the tongue as easily as Chindia or Chindonesia, someone would have coined the term long ago.
The speed with which economic relations have flourished raises two important questions equally applicable to other parts of the world. First, what happens when Chinese growth and investment slows, a process that has already begun? Second, how can Latin America forge an economic relationship that is more than just a rerun of its commodity dependency of eras past?
To work out what might happen as China slows, we should first look at how different countries fared as it took off in the 1990s. As Alfredo Toro Hardy, a Venezuelan academic and diplomat, makes clear in his book, The World Turned Upside Down, there were losers as well as winners.

Broadly, the losers were Mexico and the “Mexico-type economies” of Central America with low-cost maquiladora plants for assembly and manufacturing. For Mexico, a net importer of raw materials, including corn and soya, the rise in commodity prices accompanying China’s ascent had a largely negative impact. More important, as China’s manufacturing prowess grew, Mexico’s factories lost competitiveness. From 2001 to 2006 its share of US personal computer imports halved to 7 per cent. Over the same period China’s share more tan tripled to 45 per cent.

The winners were Brazil and the “Brazilian-type economies” of South America. Not only did China vastly increase its imports of commodities from the likes of Peru and Chile but the commodity supercycle also pushed prices of raw materials to record highs.
Kevin Gallagher and Roberto Porzecanski estimate in their book The Dragon in the Room that three-quarters of recent Latin American growth can be attributed to commodity exports. Growth rates in countries with the tightest trade links to China reached a rough average of 5 per cent.
Yet even during the bonanza years, now ending, there were concerns. Cheap Chinese imports undermined Latin American manufacturers even in countries such as Brazil with a sophisticated industrial base. The currencies of commodity exporters appreciated – a classic case of “Dutch disease” – making their manufactured goods still less competitive. Some, such as Mr Toro Hardy, worried that over-reliance on commodities might implygoing back in time” to a primary export economy. For a high-technology producer such as Brazil, he said, this smacked of neo-colonialism.
Such concerns, though they have particular resonance in Latin America, apply to other countries that have ridden China’s commodity train, from Australia to Mongolia. Many countries have bet the farm – or rather the mine – on everlasting demand from a China whose economy is now slowing.

As China decelerates from double-digit growth to a projected 7.5 per cent this year, the economies of some commodity exporters have stumbled. Brazil is a case in point. Partly as a result of slowing exports to China and falling commodity pricescopper, iron ore and coal are 30-50 per cent off their 2011 peaks – it registered average growth of just 1.8 per cent in 2011 and 2012, down from a roaring 7.5 per cent in 2010.
That process could have further to go. China’s economy may slow more sharply than expected or it may rebalance more quickly from investment-led to consumption-driven growth. The Economist, perhaps prematurely, has already declared a structural Great Deceleration in emerging markets.
In a report entitled If China sneezes, Nomura estimates the impact on several economies if 2014 growth in China’s $8tn-plus economy slips 1 percentage point below Nomura’s baseline forecast of 6.9 per cent. It finds that a 1 point fall would shave a further half-point off Latin American growth. Some countries such as Australia, down 0.7 per cent, and trade-dependent Singapore, down 1.3 per cent, would fare worse.
It is not all bad. Mexico may actually have benefited from the changing nature of China’s economy, where higher wages have breathed new life into the maquiladora system. Nor has it suffered from the fall in commodity prices.
Even in countries such as Brazil, the effects of a Chinese slowdown need not be all negative. China will continue to urbanise, putting a floor under metals prices. To the extent that its demand for hard commodities does slow, its appetite for meat and grains should rise. The key for Latin America – and for other suppliers of China’s needs – is to construct a trade relationship that maximises value added, even if that is only branding or processing raw materials. Canada, Australia and, closer to home, Chile show that being a first-rate commodity exporter does not necessarily mean having a second-rate economy.

Copyright The Financial Times Limited 2013.

"Economics Cannot Trump Mathematics"

by Tyler Durden

07/27/2013 16:27 -0400

Originally posted at Monty Pelerin's World blog,

Extreme Fear Is Reasonable 

It is nearly impossible to convince people that an economic ending is likely, perhaps inevitable. It is beyond anything they have seen or can imagine. I attribute that to a normalcy bias, an inherent weakness of experiential learners. For many, accepting something that has not occurred during their time on the planet is not possible. The laws of economics and mathematics may shape history but they are not controlled by history.

The form of cataclysm and its timing is indeterminable. Political decisions continue to shape both. The madmen who are responsible for the coming disaster continue to behave as if they can manage to avoid it.   
Violating Einstein’s definition of insanity, they continue to apply the same poison that caused the problem. These fools believe they can manage complexities they do not understand. We are bigger fools for providing them the authority to indulge their hubris and wreak such damage.

Apocalypse In One Picture

James Quinn provided the following graph. If a picture is worth a thousand words, this graph is worth millions. The route to economic demise is depicted below:

The relationships in this graph are terrifying! Debt is shown relative to GDP. GDP growth has been one-third the growth in debt for the period. That is, the economy required $3 of debt to produce $1 more in real GDP. In recent years diminishing returns to debt required $6 of debt to increase GDP a $1. Whatever the benefits of debt, they have clearly diminished, almost to zero. Debt expansion has gone exponential in order to salvage the weak growth in GDP.

To put this into a perspective the average reader can understand, think of GDP as a household’s spending. The “familydepicted above has to borrow each year in order to maintain its spending level. Imagine the condition of your family if you borrowed 6 times the amount of incremental spending each year. Then imagine the condition of your family after forty years of continuously increasing your debt levels substantially in excess of your income.

It is impossible for a family without a printing press and a cooperative Federal Reserve to engage in such behavior. The government is different, you say? Surely it is, but not necessarily in a meaningful financial manner.
Just as you would not survive such behavior, governments cannot either. History is full of examples of government collapses resulting from excessive debt and overspending. A printing press only provides the luxury of more time before the failure.

You may object that a macroeconomy is different from a family. Debt (parroting the political claim) makes an economy grow faster. The evidence shown to the right does not support this claim. Government reported GDP growth rates are shrinking as the debt expansion accelerates. Since 1965 the growth rate of the economy has been declining.

Even if you accept government GDP reporting, the chart to the right shows a trend this is pointing to an average declining standard of living. That point will be reached when the GDP growth falls below the population growth.

The US economy has been underperforming since the 1970s according to government’s statistics. That is after all the games have been played with these numbers. How much longer can these trends continue and what happens at the end? No one can reasonably answer either of these questions.

What Is Known And Not Known

Two things are known:
So long as borrowing increases faster than GDP, the ability to repay diminishes. That has been occurring for more than forty years and the differential growth rates have widened dramatically in recent years.

Not borrowing at this pace would likely have decreased reported GDP dramatically. While that may have been a proper economic response, it is now politically impossible (or highly unlikely).

Continuing to increase debt at a rate greater than GDP ensures financial collapse. Stopping or slowing down at this point likely leads to the same point. This country has maneuvered itself into a no-escape situation.

What would happen to GDP and the standard of living if borrowing were dramatically reduced? How much of the last $10 trillion in debt borrowed between 2000 and 2009 went directly into reported GDP?  Is it possible that reported GDP for this period could have been $10 trillion lower? If there is indeed a monetary/fiscal multiplier as Keynesians insist, then results would have been worse.

Answers to these questions are speculative. Those in favor of more debt argue that a calamity would have occurred had the massive rise in debt and its accompany stimulative effects not happened. For the Paul Krugmans of the world, more debt and stimulus is always the answer. All problems look like nails when you own only a hammer.

Rapidly increasing amounts of debt since 1965 have been accompanied by falling rates of growth. One may speculate what this growth would have been with different rates of debt expansion. Whether the rate of debt expansion increased or decreased the rate of real GDP is moot. Economists can use their competing paradigms to duel over this issue, but cannot come to a conclusion that is acceptable to most.

Mathematics, on the other hand, is definitive. There are mathematical limits that control the ability to service debt. Once these limits have been breached, some amount of the debt will be defaulted on. The breach point is referred to as a debt death spiral. The US has passed this mathematical point and is in a death spiral.

The political class in America, either via misguided economic policies or a deliberate attempt to hide the true condition of the country, has put us here. They will continue to employ whatever policies they believe will keep things going for a while longer.

The tragic ending has been cast. Economics cannot trump mathematics.