The US Federal Reserve will, in October, conclude its program of tapered monthly purchases of Treasury bonds and mortgage backed securities (QE3).
This is in line with the initial announcement in June last year by the then chairman of the Federal Reserve, Ben Bernanke. The tapering program began in December 2013 when the monthly target of $85 billion was reduced by $10 billion.
It will finish on schedule in October.
QE3 has not been without its critics, who have seen the cheap money channeled through the taper as underwriting artificially inflated markets for equities and fixed interest products, along with other financial assets across global markets.
One of the more outspoken critics of the US quantitative easing regime has been the governor of the Reserve Bank of India, Raghuram Rajan, who was for three years the chiefeconomist of the International Monetary Fund.
Rajan achieved some professional notoriety in 2005 when he spoke at the annual Jackson Hole economic conference, criticising the economic management of Alan Greenspan as chairman of the US Federal Reserve.
That was three years before the collapse of Lehman Brothers. Last weekend, Rajan featured in the Financial Times in its luncheon guest interview.
Asked, in the light of his earlier recognition of the global financial crisis, he replied: “The beauty of having been right once, or partially right once, in hindsight, is that now everybody expects you to be a prophet. But, the truth is, nobody really knows where the next one will come.”
Rajan has been particularly concerned about the lack of coordination between central banks, citing the US Fed for reining in QE early last year without considering the effect on emerging economies.
At his lunch he remained critical.
“Six years since the financial crisis, central banks still have their foot fully on the accelerator . . . [pushing] credit into emerging markets.
“We don’t know how this will end . . . It may end smoothly, if we let the air out of those inflated markets slowly, or by a series of mini crises. But it may be more dramatic if, one fine day, suddenly the world realises the US is going to raise interest rates quite quickly . . . then the air will go out much faster.”
Of even greater concern, he said, is a broader pattern of globalisation beset by repeated crises, as developed and developing worlds fail to coordinate, sending capital washing back and forth between them, violently destabilising their financial systems.
Rajan’s concern about the potentially damaging mobility of leveraged financial capital is directly relevant to Australia, a significant player in the global carry trade.
Americans Martin Feldstein and Robert Rubin have been leading figures in the Republican Party and the Democrat Party respectively for some decades. Feldstein, a Harvard professor, was chairman of the Council Of Economic Advisers under President Reagan. Rubin was President Clinton’s secretary of the US Treasury.
They jointly warned last week in the Wall Street Journal that the Fed’s unconventional monetary policies, where QE3 has had a major role, has potentially increased the level of excessive risk across a large slice of the US economy.
Winding up quantitative easing policies – such as the tapering program – could reveal the extent of excesses in the system.
The spread and magnitude of these systemic risks is not known. Nor are these risks confined to the US banking system or the US itself.
Compounding the potential instability implicit in this scenario of excessive risk, is the Fed’s stated intention to limit any regulatory intervention on its part of “macroprudential” policy tools. Basically, any regulatory direction from the Fed that moves beyond interest rate fixing can be described as “macroprudential”.
Feldstein and Rubin are quite sceptical about the capacity and effectiveness of macroprudential intervention in contagion-prone financial markets.
They claim that there is such a range of asset classes and asset holders, that current macroprudential tools are not nearly as broad as the existing range of systemic risks.
They cite potential red flags.
“For one, if hedge funds hold excessively priced assets that at some point start to adjust, there could be a contagion and a snowballing effect, especially given the crowded trades that are common among hedge funds.”
“That,” they write, “could affect broader markets and the economy more generally.”
Not to be ignored is the junk bond market where yield spreads on low-quality bonds have fallen dramatically.
The volume of high-risk “leveraged loans” (i.e. loans that require interest rates of Libor, the London Interbank Offered Rate, plus 200 basis points of more) have increased from $200 billion in 2010 to $600 billion last year. Covenant-light loans have grown from $10 billion in 2010 to more than $250 billion last year.
Equities, especially in the US are expensive. The S&P 500 is near record highs. Volatility across asset classes is very low and volatility instruments like the Vix Index are trading at low prices to reflect this.
In Europe, sovereign debt yields have fallen despite the fragility of the economic recovery.
The Spanish 10-year bond, for example, recently traded at the lowest rate since 1789. Last week the German 10-year bond fell below one per cent for the first time in history.
The banks have been buyers of these securities but they have to compete against a host of fund managers operating outside the banking system and are, for the most part, not subject to central bank regulation.
These include superannuation funds, insurance companies, university and college endowments, money managers, hedge funds, individuals and others.
Feldstein and Rubin are not advocating immediate action by the Fed. Only that it should take into consideration the possibility of excesses brought on by low interest rates and how it could create financial crises.
Neither they, nor anybody else will be comforted by the views of Princeton professor and former Federal Reserve vice chairman, Alan Blinder.
His summation: “There are a zillion ways it could go wrong but the simplest way is that the Fed exits [from quantitative easing] too slowly, in which case some of the fears of the inflation hawks will come true. The other is that the Fed moves too quickly – this is the one that often gets forgotten – and the recovery stalls or, even worse, gets reversed.”
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