Yellen's Fed adjusting to life in the fast lane

All good things inevitably come to an end. In the case of the US economy, it was about time that US Federal Reserve Chairman Janet Yellen brought the Fed’s five-year bond buying programme – quantitative easing – to a timely conclusion. The US economy has been hogging the fast lane of recovery for so long that last week’s decision to ease off the monetary throttle and set the stage for a new policy era seemed long overdue.

In the last six years the US has been through challenging times and it has taken radical action by the Fed to beat off recession, deflation and a punishing financial crisis. Janet Yellen’s predecessor, Ben Bernanke, needed to be a trailblazer, championing the use of zero interest rates and unprecedented amounts of bond-buying to snatch the US out of the jaws of disaster. But the US has become so hooked on cheap money that Yellen will have her work cut out, weaning the economy off its dependency, without compromising sustainable growth and full employment in the process. The last thing the US economy needs right now is a toxic withdrawal shock.

The Fed’s controversial era of quantitative easing is over, but the Fed is not about to go into a painful knee-jerk reverse just yet. Despite heading into a sixth year of recovery, the economy still needs careful nurturing. US third quarter GDP growth at 3.5% may look impressive, especially after a powerful 4.6% growth spurt in the second quarter, but weak spots remain in the economy. Consumer confidence is still wavering despite the US jobless rate falling to a six year low of 5.9%. A tell-tale sign of continuing vulnerability is the downward drift in US inflation below the Fed’s 2% CPI target. And on-going global uncertainties are another reason for the Fed to tread carefully.

Even so, Yellen’s new monetary regime is already underway. As promised, the Fed brought its monthly bond buying programme to a close, but still stands ready to keep its massive $4.4 trillion balance sheet intact for the time being. It is an important bellwether for investors as it underlines the Fed’s commitment to keep financial markets awash with more than ample liquidity to support risk-taking and investment in the economy.

The Fed’s language has assumed a more hawkish tilt too. In an important departure from past policy statements, US labour market slack is no longer described as being ‘significant’. The Fed has also downplayed global risks to US growth prospects, especially recent financial market volatility and the weakening economic picture in the Eurozone. The minutes say the Fed “continues to see sufficient underlying strength in the broader economy”. In other words, the US recovery has enough stamina to stand on its own feet.

The Fed is sticking to its belief that interest rates should stay near to zero for a ‘considerable’ time, but warns that rate rises will be brought forward if the Fed’s employment and inflation objectives are met too soon. The market still envisages the Fed will bump up borrowing costs by mid-2015, but this could be sooner now given the Fed’s conditional link to the improving economic picture.

There are good reasons why the Fed can take its time. US monetary conditions have already started to tighten thanks to the impact of a stronger US dollar. Since mid-year, the US dollar index against a basket of currencies has appreciated by 10%, equivalent in monetary terms to a 2.5% rise in short term interest rates. Over the next year this could shave as much as 0.25%-0.5% off US growth potential – no bad thing for the Fed if they are worried about possible overheating risks. Given the bullish mood surrounding the US dollar right now, the proxy tightening effect on the economy looks set to extend even more.

And as market expectations continue to discount higher US rates ahead, the impact of rising US bond yields will do the Fed’s work for it as US borrowing costs start to rise up in step.

Yellen has set the wheels in motion for tighter money without any reason to rush into it just yet. The economy is moving well under its own steam, job-creation is making good progress and inflation is not a worry. Yellen can afford to wait and see how the economy shapes up over the next few months. The Fed has done its bit for global recovery and now it is time other countries to step up to the plate.

The Bank of Japan could not have picked better a better moment with last week’s announcement to crank up growth prospects with extra stimulus measures. The European Central Bank just needs to grasp the nettle for full-blown QE and do its bit to help revitalise global growth in the next few years. 

Reprinted courtesy of the South China Morning Post - 3rd November 2014