Last week’s decision by the United States Federal Reserve Board to begin tapering off its bond-buying program known as QE3 was long awaited; nevertheless, it proved to be a surprise. While the U.S. economy has improved, most analysts anticipated that the Fed would move next year when the recovery is expected to be on firmer footing.
Instead, it began the process of disengagement by moving cautiously forward with a small cut in purchases of Treasury bonds and mortgage securities. It is the right move.
The Fed embraced “quantitative easing” as a reluctant step to inject a large amount of funds into a moribund U.S. economy. Since the Great Recession of 2007-2009, U.S. politicians have rejected traditional Keynesian measures to create demand, focusing instead on balancing the federal budget, a decision that constrained government spending at the very time that private demand had dried up. Acknowledging that the Fed’s mandate required it to keep an eye on both inflation and unemployment — the second has historically been an afterthought in its policymaking — the bank has undergone three rounds of bond purchases to compensate for the lack of fiscal stimulus. The third round, QE3, began in September 2012, and entailed a monthly purchase of $40 billion of T-bills and mortgage-backed securities. In December 2012, the amount was increased to $85 billion per month.
Being “open-ended,” the program would continue until the U.S. economy regained its footing. Fed Chairman Ben Bernanke suggested that an inflation rate of 2 percent and an unemployment rate of 6.5 percent would indicate the time had come to taper.
At its meeting last week, the Fed upgraded its economic forecast: It now anticipates GDP growth of 2.9 percent to 3.2 percent in 2014 (up from an original projection of 2.9 to 3.1 percent) while unemployment is projected to fall to a range of 6.3 to 6.6 percent (versus the original expectation of 6.4 to 6.8 percent).
The agreement by Congress on a budget also creates more certainty in the economy. In these circumstances, a recovery, while fragile, appears to be taking root and the Fed is right to begin to signal a shift in policy.
Quantitative easing has been controversial. Inflation hawks feared that the massive injection of funds would devalue the currency and trigger a new round of inflation. Thus far, those fears have been unfounded, even though the Fed’s balance sheet has swelled to $4 trillion. Moreover, the Fed remains committed to being “accommodative,” meaning that short-term interest rates will remain near zero for some time, signaling that inflation remains at bay. Most experts today worry that there is not enough inflation in the economy, not that there is too much.
A better objection is fear that the infusion of funds in this quantity will create bubbles in asset markets, and some sharp-eyed observers see that occurring. The U.S. stock market has climbed to unprecedented heights, and most market watchers credit the Fed’s easing as the primary culprit.
Absent other investment opportunities, money has flowed to stocks and the result has been record gains.
Many economists blame QE for the surge in inequality in the U.S.: Since a small share of the population holds financial assets — the top 10 percent own 80 percent of stocks — the gains have been captured by a very small proportion of society. Some see the Fed’s hand in skyrocketing art prices — records are set daily at auctions — and real estate.
Similarly there has been worry that some funds have seeped into emerging economies as investors seek higher returns, triggering inflation there. Again, there is little evidence of this.
The prospect of bubbles creates another fear: that the taper will end the easy money and trigger a sell-off as investors are forced to find higher returns. Deflating bubbles is almost always messy, but the response to the Fed’s announcement has been measured. U.S. stocks hit record highs, then fell slightly the next day. Bond yields were stable, and stock markets in Asia and Europe recorded gains.
Given the Fed’s decision, the reaction seems appropriate. The Fed has reduced its purchases by only $10 billion in total, and interest rates will remain low. The Fed remains committed to supporting the economy, and it will keep a close eye on key indicators. Its preference remains private-sector growth, and in its absence, it will provide much-needed stimulus.
The Fed meeting last week was also notable because it was the last at which Bernanke held the chair. He is stepping down after two tumultuous terms, and Janet Yellen, currently the vice chair, has been nominated to succeed him and is likely to take that post early in the new year.
Yellen shares Bernanke’s outlook and is expected to continue many of the Fed’s current policies. That idea of continuity in leadership is almost as important as the policies that are adopted. Expectations are critical to managing a modern economy, and with its decision last week, the Fed has signaled as clearly as possible that there will be no surprises in its decision making.