Cover story on “tapering”

This Fund Strategy cover story on “tapering” – the gradual reduction in monetary support for the economy by America’s Federal Reserve – was first published on 21 August. An accompanying chronology can be found here.

Are central bankers preparing to turn down the money tap? The pronouncements by Ben Bernanke, the chairman of America’s Federal Reserve, on what has become known as “tapering” have set the markets aflutter. Many argue that the world economy has reached an important turning point.

The end of the period of ultra-loose monetary policy that emerged with the financial crisis of 2008 seems to be in sight. Or at least the beginning of the end. Although quantitative easing (QE) and low interest rates are likely to remain in place for a while the central bankers seem to be signaling that things could change before too long.

The optimistic take on this development is that it shows economic recovery is around the corner. America is already showing signs of an upturn and even the eurozone, despite its recent problems, has started to grow. Most equity fund managers share this upbeat view. A net 72% expected the global economy to be stronger over the coming year according to the latest monthly survey from Bank of America Merrill Lynch (BOAML).

A more negative view on the discussion is that tapering could be premature. If easing happens too early it could damage a still tentative recovery. This helps to explain why many markets have reacted nervously to the debate. Yields on sovereign debt have risen sharply since the tapering talk began.

Emerging markets are a particular concern for many. Signs of a possible recovery in the developed world coincide with indications of a slowdown in the emerging economies. Bond yields in emerging debt have risen particularly sharply since the taper talk began. Global fund managers’ exposure to emerging market equities has fallen to its lowest level since November 2001 according to BOAML.

This article will examine the significance of the tapering discussion more closely. First, it will show the talk of easing QE fits into a broader framework that central banks are using to manage expectations including forward guidance. The parallel emergence of curbs on credit expansion in China complicates the picture still further.

After that it will look at the competing assessments of the underlying economy with a focus on America. The upbeat view will be compared with the argument that there are still fundamental imbalances in the global economy. An alternative perspective might be that, even leaving aside imbalances, the developed world has done little to resolve its fundamental structural weaknesses.

Tapering talk

The start of the tapering talk is usually attributed to Bernanke’s statement to Congress on 22 May. In a response to a question the chairman said the Fed could slow its $85 billion (£55 billion) a month asset purchases “in the next few meetings” if employment data was strong enough. Equities tumbled and the dollar rose in the immediate response to his remarks.

However, even on this level such statements are difficult to pin down. Central bankers are notoriously cryptic in their pronouncements. Slight changes of nuance are often interpreted as having great significance in the markets and elsewhere.

It is certainly the case that hints about tapering emerged before May and that there have been several attempts at clarification since then. For example, back in March the president of the New York Fed, William Dudley, reportedly said that the speed of asset purchases could be changed depending on market conditions. Since May the Fed chairman has several times amplified on his remarks although he eschews the word “tapering”.

In particular Bernanke has emphasised that his focus is on reducing the amount of QE rather than ending it abruptly; let alone raising interest rates at this stage. Jan Dehn, the head of research at Ashmore, says: “The Fed has really struggled to convey that there is a difference between tightening monetary policy and scaling back easing”.

If taken literally, Bernanke’s remarks are almost true by definition. All he has said in effect is that at some indefinite point in the future the asset purchase programme will be reduced. He has not specified any time by which it is certain to happen. From this perspective it is hard to see what all the fuss is about.

But the real importance is more likely to be what was signified rather than what was actually said. Dehn says: “The significance symbolically of course is enormous. In practice it is pretty small.” He goes on to point out that: “It is the first material policy change we have had since the beginning of the crisis. We’ have been in easing mode since [20]08-09 and now we are beginning to scale back the pace of easing.”

It should also be recognised that the importance of Fed monetary policy goes well beyond America’s shores. Despite its relative decline it remains the world’s largest economy and its interest rates remain a global benchmark. Andrew Milligan, the head of global strategy at Standard Life Investments, says: “Tapering matters because the global interest rate is now set to be on an upward path over time.” For him “We are moving into a new phase of monetary policy slowly but inexorably.”

In any case there are other subtle hints by central bankers that recovery could be round the corner. One of these is the introduction of frameworks for forward guidance. In essence this is a way of managing expectations about how central banks will respond to signs of recovery. For instance, saying that QE could be eased if unemployment goes below a certain specified threshold.

Much of the British media has focused on the introduction of this practice in August under Mark Carney’s new reign as Bank of England governor. But the Fed introduced the practice back in December 2012 while the European Central Bank brought it in July. Indeed the Bank of Canada, where Carney was previously governor, used it as far back as April 2009. Back then it committed itself to keeping its policy rate at the lowest possible level for a year or so, depending on the outlook for inflation.

At the same time as western central banks are hinting at tightening it is already underway in some emerging economies. For instance, Brazil, India and Indonesia have all raised interest rates recently. Probably most significant of all are the moves by the Chinese authorities to curb the growth of credit. Although China is not a fully-fledged market economy this could be taken to suggest that the economy may be overheating. Indeed the latest BOAML survey showed a Chinese hard landing and associated commodity collapse as the risk that most concerned global fund managers.

Optimism on recovery

The most common interpretation of the tapering discussion is that the western economies at least, headed by America, are moving towards a tentative recovery. This is reflected in the positioning of global equity managers with the third highest overweight position in American stocks in the last 10 years of the BOAML survey.

Will Hobbs, the head of equities strategy at Barclays, is firmly in this camp. “We’ve long felt that the US economy is capable of standing on its own two feet,” he says. “The recovery is starting to look a lot less fragile.”

As evidence for this claim he points to what he calls the “incredible, unprecedented snapback in corporate profits”. This view is supported by the official data published by the official Bureau of Economic Analysis. Profits have risen sharply, to record levels in nominal terms, since the dark days of 2008-09.

Hobbs also favours the ISM index, compiled by the Institute for Supply Management, as a good proxy for overall economic health. A score of above 50% indicates that the economy is improving while a score below that number indicates a contraction. The index level plummeted during the financial crisis but has since recovered sharply to generally hover above the 50% level (see chart here ).

Another key piece of good news is that the federal deficit is falling much faster than expected. Although government debt levels will continue to rise under such conditions the rate of growth is slowing. Official support is becoming unnecessary. “The US economy is able to stand on its own two feet”, says Hobbs.

He is perhaps unusually upbeat in rejecting the view that QE has played a key role in pushing up equity prices. For Hobbs it is the turning of the business cycle towards recovery that is the key factor.

That is not to say he naively expects a smooth ride in the period ahead. On the contrary, he says he expects market volatility over the summer. But for him the overall prognosis is good.

The recent news that the eurozone has finally come out of recession after 18 months of economic contraction has strengthened the optimists’ case. There are also tentative signs of recovery in Britain including a rise in manufacturing output and a shrinking trade deficit in June.

Imbalances

A more downbeat approach would be to concede that there are signs of recovery but to point to the existence of persistent global imbalances. This method involves building on the insights of double entry bookkeeping.

For those unfamiliar with this approach take a simple example. Say Mr A lends $1,000 to Mr C. In this instance it should be clear that Mr C has incurred a debt of $1,000 while Mr A has a corresponding asset. Another way of saying this is that for every borrower there must be a corresponding saver elsewhere.

Although this example will be obvious to many its application is all too often forgotten in mainstream economic debate. If one party has built up large amounts of debt then there must, by definition, be corresponding assets elsewhere. So much of America’s large debt burden has as its counterpart the build-up of Chinese assets. Large Chinese holdings of American Treasuries are perhaps the clearest example of this trend.

In broad terms Gary Reynolds, the chief investment officer at Courtiers, a wealth management firm based in Henley, follows this approach. Although he is fairly upbeat about the prospects for an American recovery he argues this alone will be insufficient to resolve the key challenges facing the global economy.

“The evidence is out there that the US is going to go into a pretty good period of hopefully trend – perhaps above trend – growth”, he says. “The fledgling signs are there.”

Reynolds points to several indicators to support this view including the deleveraging of the private sector, the pick up in house prices and the recovery of construction. He also notes there is a good chance that America could become a net exporter of energy.

However, Reynolds points out that the counterpart of excessive borrowing in America, as well as Britain and Spain, is excessive saving in China, Germany and Japan. Bringing the global economy back into balance cannot simply be achieved by reducing debt where it is high. Action is also required in the excessive savings countries.

Ashmore’s Dehn also incorporates imbalances into his analysis but for he is much more downbeat about America’s prospects while being particularly positive about emerging economies. For him America has built up hugely damaging levels of debt while the emerging economies have accumulated assets as a result of their economic dynamism.

In Dehn’s view the sell-off of emerging markets prompted by the American tapering discussion was a panic reaction. The case for investing in emerging economies remains strong.

Dehn is unusual among analysts in focusing on total debt in the economy rather than just government debt. He points out that American debt levels have surged from about 200% in 1980 to over 400% today. Although they are slightly down from their peak a few years ago such levels are, in his view, still far too high. “There is way, way too much debt in the economy,” he says.

This view has direct implications for the bond markets. In Dehn’s view a fixed income bubble has emerged in the developed world over the past 30 years. Sooner or later prices are likely to return to a more normal level.

Nor does he see any signs of a quick American recovery. On the contrary, the latest recession has particularly problematic features. “In a normal recession you go through two or three quarters of negative growth then the central bank cuts interest rates” he says. “Maybe there is a bit of fiscal stimulus. And then two or three quarters later the economy is growing at 7 or 8%.”

For Dehn America faces a pernicious choice. Either it has to face “decades of austerity” or it must promote inflation as a way of devaluing its debt. In the event he says that the inflation route is likely to be chosen. From a government perspective it would have the advantage of hitting those with marginal influence, such as pensioners, as well as foreign holders of American debt.

No doubt some experts would dismiss Dehn’s argument as unfounded doom mongering. They would point out that many have predicted rampant inflation in recent years but so far it is yet to materialise. But Dehn’s case, although contestable, should not be dismissed so easily.

Structural weakness

Those who want to consider the question of tapering more deeply might want to look closely at an article from the Economist entitled “the end of cheap money”. It starts by noting: “Money has never been so cheap and so easy to obtain. The average of short-term interest rates in America, Japan and Europe is at its lowest in recorded history.”

This might at first sight seem unexceptional but the striking thing about it was that it was published back in 2004. Nine years ago western central banks had slashed interest rates to head off concerns about deflation following the bursting of the stockmarket bubble in 2000.

Such episodes should be a reminder that the authorities have often acted to promote credit expansion over the past 30 years. “Central banks prefer to stop recessions and crises by massive stimulation, in effect building up a larger debt mountain each time, says Standard Life’s Milligan. Sometimes this has taken the form of monetary policy such as low interest rates or QE.

Governments have also encouraged the expansion of credit by the financial markets. For example, the mortgage bubble in America in the last decade was at least partly the result of the relaxation of lending restrictions.

Typically such credit expansion is explained as either a policy error or the result of financial institutions “capturing” the relevant authorities. But an alternative view would be that they represent a short-termist move by government to counteract the effects of underlying economic weakness. It is much easier to try to extend credit than to promote new rounds of investment or economic restructuring. The problem is that in the longer term such attempts at easy answers tend to create even more instability.

From this perspective the surge in debt in western economies is a symptom rather than a cause of economic weakness. It has emerged as a result of the authorities’ short-termist strategy for heading off crisis.

The poor figures for productivity growth are an important indicator showing that all is not as well with the economy as it seems. Despite all the talk of a productivity renaissance the numbers are poor (see chart two here ). Yet productivity – the amount produced by an employee in a given amount of time – is one of the most fundamental indicators of economic health.

Strangely such data hardly figures in the public discussion of economics. This is probably because the debate overwhelmingly emphasises the importance of consumption while paying relatively little attention to the productive sphere.

Conclusion

Whatever the underlying strength of the western economies the desire to maintain monetary stimulus for as long as possible is striking. One notable example is the hostile reaction to the publication of the annual report of the Bank for International Settlements (BIS), the central bankers’ central bank, in June. The report made the basic point that monetary stimulus can only buy time rather than solving economic problems.

It is not necessary to agree with all the BIS’s prescriptions to suspect something might be wrong here. The anxiety about keeping monetary stimulus going for as long as possible seems to be clouding rational debate.

Indeed one way of seeing tapering is as a means of extending monetary stimulus for as long as possible. As Carney said in a speech in December 2012 it is another unconventional policy tool alongside QE. It helps to reassure the markets and financial institutions that stimulus is likely to continue for some time to come.

It is inevitable that at some point in the future QE will be scaled back and eventually interest rates will rise from their historical lows. Exactly when these things will happen is impossible to say but it looks certain to be a protracted end game.