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Yellen Fed courts fate by reversing QE so soon

Janet Yellen
Janet Yellen's fond hope is that quantitative tightening will 'run quietly in the background'

The US Federal Reserve and fellow central banks can be forgiven for telling us a white lie: nothing would be gained from admitting that they do not know how to extricate the world safely from their extreme monetary experiment.

Fed chair Janet Yellen has finally pulled one major trigger after countless retreats. The long-awaited reversal of quantitative easing will kick off in October. 

Deutsche Bank calls it the start of the 'Great Central Bank Unwind', candidate ‘Number One’ for the world's next financial crisis. 

The puzzle is why the Yellen Fed – usually so cautious – has chosen to enter these treacherous waters when there is no strict need to do so and before it has raised interest rates to minimum safe levels. This tightening sequence makes no sense. It leaves the Fed with less of a safety buffer, and therefore more vulnerable to an external shock.

Former Fed chairman Ben Bernanke told his ex-colleagues to leave QE well alone and for as long as possible. It should kick the issue into touch and let the economy “grow into” the Fed's $4.5 trillion (£3.3 trillion) balance sheet over time. Stripped of academic circumlocutions, the message was that reversing QE is simply too dangerous.   

Mrs Yellen's fond hope is that quantitative tightening will “run quietly in the background”. It will be like “watching paint dry”. The holdings of Treasuries and mortgage bonds will run off slowly, starting at $10bn a month in October, and rising in stages to a brisker pace of $50bn by early 2019. It has all been signaled in advance. What could be gentler?

The obvious riposte is that the Fed has always argued that the QE works through the 'portfolio channel effect': forcing investors out of safe-haven assets and into equities, credit, property, and every other kind of asset. 

Central banks have published copious papers showing how wonderfully it lowered borrowing costs and compressed yield spreads. Yet the silence is deafening on the way out. "Either QE policies have an impact or they don’t. You cannot have it both ways," says Torsten Slok, Deutsche Bank's chief economist.

Winding down QE self-evidently drains liquidity and has a contractionary effect on the money supply. Once the European Central Bank cuts its purchases to zero and the Bank of Japan tightens for its own compelling reasons – it already owns 75pc of the Tokyo ETF market – the net reversal in flows could reach an annual pace of $1.8 trillion. This is real money. 

The Fed has certainly achieved its post-crisis objective of stoking asset booms, although Mr Bernanke has admitted disarmingly that nobody knows quite why. “The problem with QE is it works in practice, but it doesn’t work in theory.”

The combined $14.4 trillion accumulation by the big central banks has played havoc with asset valuations. The Shiller (CAPE) price earnings ratio for the S&P 500 index is currently at 30.68, higher than the speculative peak in 1929.

The Bank for International Settlements warned this week that use of global margin debt used to buy equities is now more extreme than during the dotcom bubble in 2000. ‘Leveraged loans’ have jumped to an unprecedented $1 trillion, three quarters on ‘covenant-lite’ terms.  As the BIS says, this is only sustainable as long as central banks keep bond yields pinned to the floor, and it precisely this that  is now coming into focus.

Federal Reserve
The long-awaited reversal of quantitative easing in the US will kick off in October

"The persistent elephant in the room remains the risk that bond markets are underestimating the pace of Fed tightening ahead,” says the Institute of International Finance. “Yet credit spreads still reflect little concern, while stock market valuations continue to soar as earnings revisions lag price gains. Current market pricing can thus be seen as a game of chicken.”

Eight years of leaked liquidity from the West has destabilized the East, although China needed no encouragement. The world's debt ratio was already at a record 276pc of GDP just before the Lehman crisis. It has since jumped to 327pc as emerging markets let rip as well. 

Nothing like this has ever been seen before. Nobody knows – including Fed officials – how much monetary tightening it will take to detonate this combustible material. The BIS says it is close to becoming  a ‘debt-trap’ for policy-makers.

What is so peculiar about our current episode is that so much monetary stimulus across the world has failed to generate any meaningful inflation. The Fed's key measure – core PCE – has been falling all year and is back to 1.4pc. A  large part of the eurozone still has one foot in deflation even today.

This is doubly bizarre given that unemployment has dropped below the 'NAIRU' floor to 4.4pc in the US. It has become harder than at any time in living memory for employers to fill job vacancies. The US labour market is as tight as a drum. 

The haunting worry for Janet Yellen is that this proves to be a replay of 1965 when inflation looked as tame as it does today. The pressures were building invisibly. Prices suddenly rebounded like a coiled spring breaking loose. The wage-price spiral of the late 1960s had been born. 

Professor Yellen has to wrestle with the possibility that the 'China effect' and the 'Amazon effect' – argot for globalization and technological change – have not in fact nullified the venerable Phillips Curve. They may merely have delayed the effect.   

We should have sympathy for central banks as they navigate these reefs, yet it is still very odd that the Fed has chosen to reverse QE so soon rather than raise rates and restore 'Wicksellian' equilibrium.  

It typically takes rate cuts of 300 to 500 basis points to fight recessions. During the Lehman crisis the Fed ran out of ammunition after 475 points, which is why it resorted to QE. The 'synthetic' total was 850 points of loosening. Yet the recovery was still the weakest since the Second World War. 

Today the Fed has just 100 basis points to play with in a crisis and the bar to fresh QE – if needed again – is rising fast. Krishna Guha from Evercore said the Fed board faces a "wholesale turnover" within months as President Trump picks a new chairman, both vice-chairs, and probably five governors. The character of the institution is about to change. Mr Trump’s brigade will be much more hostile to QE.

"Much of what has been taken for granted about the Fed is under threat,” says Russell Jones from Llewellyn Consulting. “There is a serious possibility of error, and the danger is that policymakers find themselves obliged to jump from one discrete path to another, which could elicit traumatic consequences.”

So we face a world where debt ratios are vertiginous, where the Fed has no scope to cut rates in a recession, and future QE is ruled out until matters are absolutely dire. As the saying goes in central banking, this is “driving without a spare tyre".

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