After a few weeks of relative tranquillity, volatility came back with a vengeance last week. The Dow Jones index lost 6.4% and European stock markets were hit even harder as fears about the strength of the global financial system and economy continued to mount. Growth fears are, of course, nothing new. There was always scepticism about the strength of the recovery out of the great recession, and during the last few months there has been mounting evidence that growth is in fact slowing across the world.
With the options for future fiscal stimulus limited, many turned to the Federal Reserve and hoped it would be able to do something to support the economy. In his Jackson Hole, Wyo., speech in August, chairman Ben Bernanke signalled that he preferred some fiscal response but that he was ready to act if needed. And this week, after a special two-day meeting the Federal Open Market Committee announced a plan to twist its bond holdings to push long-term rates even lower than they are today.
But the announcement of this limited monetary stimulus couldn't overcome the barrage of bad economic forecasts, including one from the Fed itself. And this is a trend that could likely repeat itself over time. With policymakers unwilling to do anything other than timid steps, it will be hard to get the attention of a market fixated on the potential for a new crisis.
What the Fed Is Doing
The Fed is running out of tools. The
traditional ones at its disposal were exhausted long ago. The
federal-funds rate was taken down to essentially zero in December 2008,
and there isn't any room to go any lower than that. So the Fed then
moved to a programme of quantitative easing, essentially printing money
to buy Treasuries and other bonds in an effort to lower yields on those
investments and expand the size of the Fed's balance sheet.
The Fed did this during the height of the crisis from 2008 to 2010 and then again in the summer of 2010, and these moves mostly achieved the goals that the central bank had laid out. Mortgage rates fell, and the paltry yields on fixed-income investments helped push investors into riskier assets, such as stocks, pushing those prices up.
But it is unlikely that the Fed will embark on a third round of easing. There were plenty of detractors of the first two programmes. Critics argued that that rushing that much money into the system would lead to unbridled inflation, and they argued that the effectiveness of easing was waning. Furthermore, these detractors have grown in numbers and influence since the end of the second round of easing, making it difficult for Bernanke to print more money even if he wanted.
That brings us to the easing the Fed announced this week. All of the bonds bought during the previous quantitative easing have swelled the balance sheet of the Federal Reserve; the central bank now owns $1.6 trillion in Treasury securities. The Fed is now going to sell $400 billion of short-tern bonds and then turn around and use the proceeds to buy long-term bonds. So at the end of the programme, the Fed will still own the same dollar amount of Treasury bonds, but the portfolio will have a longer maturity.
The idea is that having hundreds of billions of purchases flow into long-dated Treasuries will raise the prices of those securities, hence lowering long-term Treasury yields. Lower long-term rates should bring down mortgage rates, the rates that all kind of borrowers pay and help boost lending and the economy.
Will It Work?
It's not clear how much good this programme is
going to do. One of the reasons that borrowing is so depressed is the
lack of demand for loans. Lowering rates further (from already-very-low
levels) is not likely to have the impact of creating a big boost of
demand. It will certainly help at the margins, but given how much easing
there has already been and the major structural problems facing the
economy, this is likely not to have a major impact.
And as First Trust Advisors' chief economist Brian Wesbury pointed out, the move won't have a major positive impact on the housing market either. The reason that people aren't tripping over themselves to buy homes isn't that mortgage rates are too high, it is the 20% down-payment requirement and other loan terms that are keeping people from borrowing. Again, slightly lower rates might induce some people to buy, but the rates aren't going to suddenly turn around the moribund housing market.
This programme was widely expected to be announced so why did the market react so negatively to it? The issue was the discussion of the economy in the Fed's statement. The Fed said that economic growth remains slow and that "there are significant downside risks to the economic outlook, including strains in global financial markets." The Fed chooses its language very carefully, and it is clear that it sees major potential problems on the horizon. But even though the FOMC admits there are big issues, the twist was the only policy response Fed officials could muster. And even that limited policy resulted in three dissenting votes from the board of governors.
This doesn't give the market a ton of confidence that policy can be made much more accommodative in the face of a slowdown. Any response would likely have to come from the fiscal side, and with a presidential election just a little over a year away, there isn't much hope for progress on that front. So the real concern is that the global economy is facing a number of real, quantifiable threats, from the eurozone crisis to unemployment in the United States, but leaders aren't willing (or able) to enact polices to tackle these problems. Until more effective policies are proposed, expect to see the market continue to shrug off these more timid responses.
What do you think? Will this new easing make a difference? Can it help solve some of the intractable problems the economy faces?
Bearish markets editor Bearemy Glaser is the worry-prone alter-ego of markets editor Jeremy Glaser. Each week, Bearemy will share what's topping his list of concerns and invites you to reply or add your own in the comments section below.
