Barack Obama‘s decisive victory over Mitt Romney in the presidential elections has cemented the future path of monetary policy under Ben Bernanke. After unveiling a fourth round of long-term asset purchases, or quantitative easing, and a new threshold-based guidance, the Federal Reserve has put itself on a path of unlimited purchases of Treasuries and residential mortgage-backed securities (RMBS) until the unemployment rate falls. The FOMC’s natural rotation will only strengthen the Chairman’s control of the committee, while an Obama Presidency and a Democratic Senate guarantee a continuation of current policies, either under Bernanke or Vice Chair Janet Yellen.
Thus, interest rates will remain repressed through 2013, the U.S. dollar should depreciate moderately, and stock markets will continue to receive masses of liquidity.
Bernanke and several of his central bank colleagues around the world have unleashed a new era of monetary policy, marked by zero-bound nominal interest rates coupled with unprecedented and massive balance sheet expansion. In this post-financial crisis world, the Fed has taken a Keynesian edict and turned it on its head: instead of the government stepping in after a crisis to make up for the loss of aggregate demand from the private sector, it has fallen to central banks.
Through that process, the Federal Reserve has become the most important market participant, flooding markets with liquidity and owning more than a third of the Treasury market by the end of next year, according to Barclays’ economics team. The latest iteration of their asset purchases, or QE4, consists of $40 billion a month in RMBS purchases and $45 billion in unsterilized Treasury purchases, meaning the Fed’s balance sheet will grow at a rate of $85 billion until the Fed sees a substantial improvement in labor markets.
The Fed is set to turn even more bullish in 2013, as its natural rotation sees two centrists and Jeffery Lacker, head of the Richmond Fed and a lone dissenter in the FOMC, replaced. In their place will come Esther George of the Kansas City Fed (a moderate hawk, which means she’s mildly opposed to more accommodation) and James Bullard of the St. Louis Fed (who has the potential to be a dissenter, according to Barclays), along with ultra-doves Charles Evans and Eric Rosengren. Furthermore, Minneapolis Fed chief Narayana Kocherlakota, a former dissenter, has quietly moved to a more dovish stance, adding further support for the Chairman.
One can’t blame Bernanke for trying to spark growth in an economy that has struggled to get off the ground since the 2008 financial implosion. A divided government has created artificial threats like the fiscal cliff, while the fear of fiscal unsustainability has increased calls for austerity. After interest rates fell to zero, Bernanke and the FOMC pushed down longer-term rates through asset purchases. Flattening the yield curve, the Fed has sought to ease credit conditions. The intention is to help homeowners re-finance mortgages at lower rates, allow consumers cheaper financing to buy cars, and give firms favorable borrowing rates.
Bernanke’s low rates have effectively “helped housing and the auto industry,” according to Raymond James’ chief economist Scott Brown. Automakers like General Motors and Ford have seen sales recover, while homebuilders like KB Home and Lennar have been on a tear this year. But the Fed’s ultra-accommodative stance has been “a mixed bag for banks.” Major names like JPMorgan Chase and Wells Fargo have access to cheap money, but their lending margins end up being squeezed by a narrower spread between long- and short-term rates.
Detractors of the Fed have argued it has distorted market action. And indeed it has, interest rates have been at record lows for years, with yields on 10-year Treasuries hovering near all-time lows. The issue of the Fed’s exit strategy has been raised on several occasions, as observers note a balance sheet approximating $4 trillion (if asset purchases continue through all of 2013) has to be unwound at some point. Goldman Sachs’ research team estimates that economic growth will pick up in the second half of 2013, sparking a “gradual but steady rise in bond yields” that takes real rates on 10-year Treasuries to 2.2% by the end of 2016 and 3.75% by 2016.
The Fed’s current strategy consists of both zero-bound rates and asset purchases. In their latest FOMC meeting, the committee agreed to set numerical thresholds for rate hikes, which are necessary but not sufficient conditions: the unemployment rate must fall to 6.5% or below, and the one-to-two year inflation projection should be at or below 2.5%. The Federal Reserve expects joblessness to fall to those levels by mid-2015; Barclays estimates unemployment to hit 7.5% by mid-year and 7% in the fourth quarter of 2013. They also expect the Fed to end its Treasury purchases by July, completing its RMBS program in December.
Bernanke’s term is set to expire in early 2014, and there’s speculation he may step down. The public opinion is divided; a report by Andrew Ross Sorkin indicated the Chairman isn’t too sure about a third term, while Raymond James’ Brown believes the Bernanke will stay around to finish the job. If he doesn’t stay on board, Vice Chair Yellen is expected to take the helm, Barclays’ team suggests, as the political balance will remain unchanged until the mid-term elections of late-2014.
The Fed has been one of the main players in global markets over the past few years. Since the financial crisis, Bernanke has taken a proactive role, first to avert a global meltdown and then to support a frail economic recovery. He’s won himself much praise, and as much criticism, but has held steady. Many questioned whether the Fed had the firepower. Bernanke always claimed he did, and he’s clearly put his money where his mouth is. The real question now is, will it finally work?
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