Back in June, Ben Bernanke told investors at a news conference that the US Federal Reserve might start scaling back its bond purchases, which have been the cornerstone of its financial stimulus program since it ran out of any further room to lower interest rates. At that point, the stock market reacted very badly, with stock prices falling 4% in just two days and bond yields shooting up in the other direction. Quantitative easing was seen as still being the savior of the US economy, and any hints that it might go away had investors running scared.
Fast-forward six months, and the Fed has started to make good on its promises. On December 18th, Ben Bernanke held his final news conference as Fed chairman, and used the opportunity to announce that the Fed would start tapering its bond purchases starting in January, 2014. Strangely enough, however, rather than taking another nosedive, markets decided that they actually liked the news and were up 1.7% the day of the news conference, while bond yields were largely unchanged. Exactly what has changed in the last six months, and why should investors and businesses feel more confident that the Fed is now doing the right thing?
One key reason is that the economy really is doing much better than it was six months ago. Back in June, unemployment still stood at an uncomfortably high 7.6%, and it was by no means clear that the US economy was on the way to recovery. However, since that time, unemployment has fallen to 7.0%, with the economy continuing to add jobs at an encouraging rate. In fact, the US has added 2 million jobs this year, and the trend looks set to continue. There are also other encouraging signs – for example, despite a few stutters, the housing market appears to be on its way back, and car sales are robust. In fact, US consumers currently have $845 million in outstanding car loans, which is the highest level seen since the Federal Reserve started tracking these back in 1999.
Another important factor may be that some investors actually doubt that quantitative easing has had much of an effect on the economy – for instance, see Ken Fisher’s Betting Against Bernanke article in Forbes. In fact, a recent study by a leading economist suggested that of the $85 billion the Fed has been pumping into the economy each month, more than 80% of this is still sitting on banks’ balance sheets – rather than making it out into the real economy. If this is true, then that is only about $17 billion a month that is actually getting to where it does some good – in the pockets of US businesses. In other words, any lack of available business financing is more a result of the unwillingness of banks to lend money, rather than them not having the cash on hand to be able to do this.
Because of this, what businesses should care more about is the ability to borrow at relatively low rates. In this, Bernanke was very clear. His statement on Wednesday indicated that short-term rates will remain essentially at zero even when unemployment hits 6.5%. In the past, 6.5% was seen as a trigger for interest rate rises, but it now appears that this form of stimulus will continue for long after that level is breached. In fact, the consensus among economists is that the Fed will not raise rates for at least another year, and the Fed’s own forecasts predict that the overnight rate will remain at 1% even at the end of 2015.
Another thing that is heartening is that the Fed is apparently going to taper bond purchases very gradually. In fact, they are only reducing their purchases from $85 billion to $75 billion in January. Even if they announce further tapering measures during the year at each of their policy meetings, that still means that they are likely to pump $500 billion into the US economy in 2013.
Finally, tapering may push up long-term interest rates to some extent, even if the Fed keeps short-term interest rates at the same levels they are today. This may sound like a bad thing for businesses, but it actually may be beneficial. If there is a larger spread between short-term rates and long-term rates, this makes it more attractive for banks to lend – which should result in more loans being available to businesses, albeit at somewhat higher rates than they are today.