Tag Archives: quantitative easing

Bernanke’s Legacy: Not Yet Determined

After eight turbulent years, Ben Bernanke’s term as Chairman of the Federal Reserve has finally come to an end. According to the Wall Street Journal, “[Bernanke’s term] spanned the tail end of a boom, a bust that threatened to rival the Great Depression and a weak recovery”. I think this is quite an accurate summary of the past eight years, however, it glances over the tough decisions Bernanke had to make. As Fed Chairman, Bernanke was in charge of determining the appropriate monetary policies for each of these situations.

Although Bernanke’s legacy will be better assessed a few years down the road, there are some interesting statistics we can consider from during his tenure. The first statistic is that of stock market returns. According to the Wall Street Journal, “The S&P 500 gained about 39%. An average annual return of 4.2% is nothing to sneeze at given the roughly 2,000-point swing in the index from peak to trough to recent peak”. The stock market was able to rally to new heights following a dramatic collapse during the financial crisis of 2008-2009. The volatility of the S&P 500 is representative of the business cycle from the perspective of financial markets.

Another important statistic from Bernanke’s tenure is regarding the Fed’s swelling balance sheet. According to the Wall Street Journal, “When Mr. Bernanke became chairman, it was $863 billion. Upon his leaving, it was $4.14 trillion”. The expanding of the Fed’s balance sheet can be primarily contributed to large-scale asset purchases (known as quantitative easing). Quantitative easing, however, is a large source of controversy. Despite his intentions to flatten the yield curve, Bernanke’s decision to conduct unconventional monetary policy caused the Fed’s balance sheet to become larger than ever. Bernanke was forced to take this route because he could not make interest rates negative. A large reason for the disapproval of Bernanke is probably due to quantitative easing, which I think this is reflected in a Gallup poll of 1,020 adults taken January 25-26. According to the Wall Street Journal, “Democrats, Republicans and independents all liked Mr. Greenspan in 2006. This time around, Gallup found, opinions of Mr. Bernanke split along party lines: Democrats approve of him, Republicans don’t and independents are divided. Households making $90,000 or more a year tend to approve of the job Mr. Bernanke’s done, 54% to 35%, while lower-income families are more even equally divided on his performance”. I think the disapproval by Republicans is due to their preference of smaller government. The Fed’s massive balance sheet is a risk to the taxpayer and the large-scale asset purchases represents significant government intervention into the economy. I think the approval by households making $90,000 or more a year is because wealthier families have felt more of the recovery (especially if they have been invested in financial markets).

Alan Greenspan, who was Fed Chairman before Bernanke, was more popular than Bernanke when he left office. Greenspan’s Fed did not experience anything remotely like the financial crisis of 2008-2009. Thus, Greenspan’s Fed was able to stick to conventional monetary policy. Unlike Greenspan, Bernanke’s Fed undertook a number of controversial and unorthodox policies in order to prevent another Great Depression. Looking back, it seems that Bernanke should be credited with saving the U.S. economy. If he was, then his approval rating would likely rise.

Regardless, I think it is way to early to assess Bernanke’s legacy. We must watch and see how the economy performs and how the Fed unwinds its massive balance sheet. For example, soon after Greenspan left office the housing bubble exploded. The calm years of his tenure culminated in the financial crisis. Although it is hard to identify the exact source of the housing bubble, there are a few reasons to place some fault on Greenspan’s Fed. Greenspan kept interest rates low for an extended period, which some believe allowed the housing bubble to form. In conclusion, time will play a vital component in Bernanke’s legacy.

Revised:The El Nino Effect in Economy: How QE flooded China

Don’t get fooled with the title, I am not talking about ecosystems here.

It has occurred to me that QE’s effects on China are analogous to the El Nino effect in ecology jargon. El Nino typically results in heavy rain falling on the lands of Southeastern Asia, when it should have dropped on the land of North America.

So what do I mean by this analogy? Essentially, I meant that QE has not flooded U.S. with astronomical amount of dollars as it seems to, but instead has been flooding China, albeit seemingly far-fetched. In economic term, the money FED created has not cause inflation in U.S, but unintentionally cause inflation in China.

How did this happen?

First, I want to address why U.S inflation rate unruffled. QE is not a conventional tool that will increase money supply. This is because QE is a game played between FED and its affiliated banks. FED swapped money with less liquid assets on banks’ balance sheets in order to increase liquidity. Note that this does not directly increase money supply to the economy, because banks are so risk averse to lend out any money FED created on their bank account. What’s more, as long as U.S. economy is far from operating at full capacity, so there is no need to worry about inflation. 

However, what QE did cause is that yield rates of most of U.S. assets have been pushed down to zero. If you are an U.S. investor, what would you do?

Well, if I were you, I will turn to the international assets market. And It turns out that China is the ideal place to invest idle money in. From my last blog, I wrote about how rising RMB and climbing interest rate had attracted hot money. But don’t get me wrong—I am not saying that the hot money that fled U.S. immediately set China on fire. There is a long story (yet interesting one) of how this unresolvable inflation in China come into fruition.

As I said in my last blog, China Yuan is now adjusting towards equilibrium exchange rate. In which case RMB rises against USD. U.S. investors will be better off even if they invest in nothing after exchanging dollar into Yuan—just this sheer move will benefit them a lot, let alone the higher investment return in China.

It is important to note that money does not flow in to buy Chinese assets, because Chinese government does not allow unqualified foreign investors to invest in Chinese capital market. But if foreign investment is allowed, then I imagine there would not be the mess as we see today, because theoretically contiguously arbitrage will eventually push down China’s asset yields, until it is no longer profitable for U.S. investors.

If this money did not directly go in Chinese capital market, where did they go? Well, it turns out, they went into PBOC, piling up foreign reserves. Please see the chart I made below to get an idea of how China’s Foreign exchange reserves had exploded. The figures are from PBOC.


Essentially, PBOC bought USD from exporters, or who ever want to exchange dollar into RMB.Every dollar went into China last year became a little more than 6 Yuan, which went directly into circulation. This way, more and more money supply drove up inflation. See this analysis from Bloomberg and you will find people sharing the same concerns. In order to offset this the inflation, PBOC raised the required deposit reserve ratio again and again. An ever-increasing interest rate in turn attracted more and more hot money from U.S. into China.

So you see the pattern: high interest rate leads to hot money inflow. Hot money inflow leads to higher foreign reserve and more money supply in China, which in turn leads to higher inflation. To curb inflation, PBOC rises interest rate once more. So on so forth. This is a vicious circle, a trap that too hard to escape from.

Of course,  China is worried. You might wander: why doesn’t PBOC just stop this circle by not intervening in foreign exchange market? You might justify your proposal by arguing that arbitrage between U.S. and China will eventually make investing in China no longer profitable. This is theoretically true.But as I indicated earlier, if PBOC freed up the grip on foreign exchange market, it would be a huge blow on exporters.

I will write in my next blog about why the in flow of hot money not only induced inflation, but also played a part in causing the shadow banking issues in China.

Fed Ignore Emerging Market Slump

The Federal Reserve followed expectations on Wednesday and voted unanimously to taper the current quantitative easing scheme, from $75 billion in January to $65 billion in February.  The Fed also extended their reverse repo experiment at the New York Fed and reiterated their commitment to short term interest rates being zero for the near future.  Although these policy actions were in line with expectation, some had been calling for the Fed to halt tapering to prevent the current crisis in foreign markets from getting any worse; however, the Fed ignored the current slump in foreign markets, highlighted by the weakening Turkish lira and South African rand.

A weakened currency hypothetically should help the net exports of these emerging markets by making the products cheaper to foreign buyers.  However, a weakening currency also make foreign debts larger in terms of domestic currency, and thus harder to pay.

Although the slump was certainly a complex mix of many factors, the planned reduction in quantitative easing is being blamed as a factor for the capital outflows from emerging markets.  The idea behind these claims is that as the government reduces the amount of stimulus through QE, investors will have higher available profits in the domestic markets, because the government won’t be driving up prices as steeply.  Thus, investors will take money out of the the riskier emerging markets to the more stable returns of the domestic market.

By continuing with the intended tapering policy, the Fed made a decision not to consider the potential adverse effects of their decision on foreign markets.  In fact, “Fed officials made no mention of these trends in the statement released Wednesday.”  In recent years, this has been the general strategy of the Fed, with chairman Ben Bernanke stating in 2011, “It’s really up to emerging markets to find appropriate tools to balance their own growth.”  Foreign central banks have taken this policy to heart in recent days, with the Turkish central bank raising it’s overnight lending rate over 400 basis points , and other small central banks enacting similar policies.  While their policies haven’t been very effective, these emerging markets clearly understand that the U.S. will not shape their policy to accommodate them.

I believe that the Bernanke and the Fed made the correct decision not to react to the fluctuations in the foreign markets in their policy decisions.  Some critics believe that many of these emerging markets had entered into a sort of bubble spurred on by high liquidity and large capital inflows, and thus a weakening in the markets were only natural.  Also, today, the emerging market currencies that were hit hardest last week have now recovered slightly, and are trending in a direction favorable to foreign governments.

Furthermore, I believe that the Fed should enact the monetary policy that is best for the U.S. economy.  Since the U.S. economy is not highly dependent on emerging markets, the Fed probably shouldn’t put too much thought into how their policy will affect emerging markets.  Also, if the U.S. economy improves overall, the foreign markets stand to benefit; what is good for the U.S. economy is good for the emerging markets.


Bernanke goes out without a bang

It didn’t end with fireworks. Instead, all ten Federal Open Market Committee officials shook their head in agreement as Wednesday’s meeting ended. The taper, as Chairman Ben Bernanke announced last week, would continue in February by cutting another $10 billion from the Fed’s purchases of Treasury bonds. As the U.S. continues to grow modestly month-by-month, most are in agreement that stimulating the economy is still needed, but less and less. Bernanke’s eight year run as chairman of the Fed will come to its end sometime in February, and the biggest news from his last meeting was that he could finally find a consensus for the first time in over two years.

As Janet Yellen prepares to take the reins, her first big challenge may not even be within the U.S. The only real obstacle to whether Wednesday’s decision would go through was the news coming from developing economies around the world, whose inflation grows and interest rates rise as the U.S. cuts back on their bond buying. As U.S. interest rates rise, investors are bringing their money back from abroad. The sudden withdrawals from these markets, including Turkey and South Africa, in particular, are putting pressure on these foreign currencies as they scramble to bring their interest rates back up. Their actions may have larger consequences, as “[Turkey and South Africa’s] rate increases could only raise the pressure on other central banks in emerging markets with fiscal concerns to take similar steps.” (Lauricella et al, 2014) Historically, the Fed has taken a position that it will do what is best for America and the other central banks will have to fix their problems on their own. On Wednesday it was no different.

Things are looking up at the Fed as Yellen comes into her term. The unanimity seen this week at the Fed is a good sign, and brings increased confidence that the Quantitive Easing (QE) plans have done well as they continue their descent. However, if U.S. economic data can continue to show positive signs (the U.S. unemployment rate dropped below 7% in December for the first time since 2008), the Fed may be back to business as usual – pushing and pulling the interest rate. However, the Fed’s between-the-lines dialect was modest on Wednesday as they continued to call U.S. economic growth “moderate.” For the foreseeable future, interest rates will stay low, growth will stay moderate, and the Fed will stay its course. On Wednesday, it seems that no news was good news, at least for the U.S.

Featured articles:

Hilsenrath, Jon, and McGrane, Victoria, “Fed sticks to script on paring bond buys,” The Wall Street Journal. Link

Lauricella, Tom, Katie Martin & Tommy Stubbington, “Investors face shift in markets as Fed scales back stimulus,” The Wall Street Journal. Link

A tale of three markets

There are some interesting feedbacks on FED’s tapering from three markets: stock market, debt market, and emerging market.

Ignoring the felling stocks market triggered by a global selloff of emerging market assets, the Federal Reserve concluded its two-day policy meeting with a decision to continue tapering its stimulus program, cutting another $10 billion from its monthly bond-buying program. They are now buying “only” $65 billion a month in bonds.

The central bank did this because it’s confident in the pace of recovery and growth prospects in the U.S. The unemployment rate targets of 6.5% and inflation targets of 2% are met, so there is no reason not to fulfill its earlier promise.

Although emerging markets had been hoping FED would not add more salt to the wound by tapering at this particularly hard time, they have no reason to complaint if FED does so(which it did). Fed officials respond that they can’t be asked to take responsibility for economies outside of their mandate.“It’s really up to emerging markets to find appropriate tools to balance their own growth,” Mr. Bernanke said in 2011, when the Fed was being blamed for sparking higher food and energy prices abroad.

Why Fed would ignore the falling stocks market? The FED seemed to put less emphasis on the recent decline in stocks caused by emerging market selloff, because it believe it is only temporary.  Moreover, FED’s dual mandates does not include protecting stocks markets from falling, either. The reason why FED tapering might be hated by so many stocks investors is because more investors would now switch to less risky assets. Even if they like risk, they had better not to miss out the potential gain on the reviving debts market, which is now generating quiet a hectic.  

CFOs wrestling with whether to issue fixed- or floating-rate debt. Investors have been snapping up floating-rate bonds because they offer protection from rising rates.For companies, these bonds can reduce borrowing costs and diversify their investor base. The risk, however, is that if interest rates rise faster than expected a company might pay more than if it had sold fixed-rate debt.

Nonetheless tapering is a hard pill to swallow for emerging markets, since the hot money that fled from safety years ago will now fly back to safety.  Assets related to emerging markets will now be even more unfavorable. China, the benchmark for emerging market, has not respond significantly to this news.  But the overall impacts tapering has on China is not to be ignored. Hot money fleeing China will surely reduce the upward pressure on RMB, a good news for exporters. However, the housing market that have been sustained by hot money will face a significant cash out to the extend that the bubble might burst eventually. If the housing market crashes down, shadow banking issues will also reach to a new stage where large scale defaults is unpreventable.

As for now, much of the China is still asleep. We can only wait and see how China will react to this lunar new year gift signed “Federal Reserve Bank”.


Fed Tapering and Emerging Markets

Today at the January Federal Open Market Committee meeting the Federal Reserve decided to uphold its last goal of cutting back the bond purchasing by an additional $10 billion per month to lower the total purchases to $65 billion a month, from $75 billion. (WSJ – Stocks Sink as Investors Retreat from Risk) The members of the FOMC voted unanimously 10-0 in favor of cutting the purchases of Treasury bonds and mortgage-backed securities. (WSJ – Fed Sticks to Script on Pairing Bond Buys) The announcement to continue decreasing quantitative easing came amidst a weak December job report and the recent fall in emerging markets.

This announcement is a testament to many investors that the Fed is committed to its promise of ending quantitative easing in 2014 and the growing strength of the United States economy. According to guidance given at today’s meeting, the Fed believes that under current conditions the US economy can sustain a 3% growth in 2014 and over 3% growth in 2015. According to Ian Shepherdson, Chief Economist at Pantheon macroeconomics, “the clear Fed default position is that tapering will continue; it would take serious US weakness or a real emerging markets disaster to make the Fed pause.” (WSJ – Fed Sticks to Script on Pairing Bond Buys)

In regards to emerging markets the announcement is a clear sign that the Fed is not sympathetic towards the struggles of emerging economies. The Fed’s official response to the concern of emerging markets is that “[the Fed] can’t be asked to take responsibility for economies outside of their mandate.” (WSJ – Emerging Markets Fight the Fed) The Fed’s response leads me to think one of two things. Either the models from the Fed signal that a catastrophic emerging market meltdown is unlikely to occur/have little to no effect on the US or Ben Bernanke is trying to ensure that he honors his commitment to end quantitative easing before his term finishes at the potential cost of another global market meltdown.

Despite the Fed’s policy on not entertaining the responsibility of other economies, one must believe that the concern of an emerging market meltdown was brought up at the FOMC meeting today, especially after concerns of emerging markets led to the biggest single day decline in the DOW since June. This would lead me to believe that today’s decision was more than Bernanke just covering his rear before he leaves on Friday. For this reason, I believe that the emerging market sell-off will likely be isolated to countries like Turkey and South Africa, and countries with stronger fundamentals such as Mexico will be able to rebound once the market corrects itself. Overall, the recent domestic decline in equities is likely attributed to market noise and the news of the Fed continuing tapering should be viewed as a signal of strength of our domestic economies, rather than a potential weakness.

(Revised) Thoughts About Negative Interest Rates

After class recently, I immediately began to regret not heeding the words of Prof. Frank Thompson last semester when he urged us to attend Miles Kimball’s seminar on how to evade the zero lower bound on interest rates by using electronic money. So after a little back and forth on the trove of tools that the FED has access to and where they could turn when they exhaust those tools, I took to Prof. Kimball’s blog and did a little bit of digging around.

I will say — the idea of achieving negative interest rates especially through the use of electronic money is one of the most interesting ideas in monetary policy I have ever come across.

Now obviously Miles has written about it and compiled information to a much greater and more sophisticated extent than I will here, but I think it is worth the brief explanation and a few thoughts more. The proposal being made by Prof. Kimball, as I understand it, involves the institution of electronic money by the government and the decommissioning of a portion of dollars from circulation. A government would institute an enticing exchange rate that would make people want to hold electronic dollars instead of regular ones, and thus the idea of negative interest rates become possible because noone is holding paper (or they are at a loss to themselves). In terms of interest rates, the FED would set the FFRate (interbank lending rate) and then set the rates for both paper and electronic dollars, doing so in such a manner that it becomes much more beneficial to hold electronic money over paper dollars again. The removal of paper from the system would then allow the FED to set negative interest rates and spur spending because if people just let the money sit there, they lose value!

Looking today (as many of the links on Prof. Kimball’s site show), central banks are starting to realize that the negative interest rate “tool” might be something that they need to consider in the environments presented in the last 7 or so years. In fact, in a WSJ article from last November, points to Mario Draghi considering the use of negative interest rates by the ECB. (WSJ) The problem with negative interest rates in a traditional monetary environment would be the fact that there could be a run on the banks and people just hiding currency under their mattresses.

Maybe one of the best recent examples of why these negative interest rate policies might be a solution to monetary problems that cannot be solved by bond buying is in Japan. In the last year, Japan’s finance minister Shinzo Abe embarked on a bond buying escapade that makes Mr. Bernanke’s QE program look small in terms of bonds bought over GDP. We all know how low interest rates are supposed to spur domestic investment, but looking at a deeper level what QE programs like “Abenomics” do is weaken the currency. Logic says that international consumers see this weakness in the currency and want to buy goods in yen terms because they get more “bang for their buck” thus compounding the spur in investment. However, in yesterday’s article in the WSJ, Mitsuru Obe shows that Japan’s most recent trade deficit was the worst on record and that while export values have risen sharply, export volumes remain the same (WSJ). Companies are not moving their production back home which may present a flaw in the logic having to do with how the spur in investment mentioned above is supposed to work.

I am of the opinion that Japan is dealing with not just a bond buying or purely monetary issue, if you will. Japan is dealing with a cultural issue that has set in from years of deflation; people are content to say, “why should I spend today when it will be cheaper to do so tomorrow?” This is where I believe negative interest rates could attack complacency to let money sit and “wait until tomorrow” or make people believe that the government’s attack on deflation is a serious one. By inducing negative interest rates in a manner such as the one Professor Kimball has suggested, Japan could “convince” many of these large companies like Toyota, etc to spend their money now rather than sit on it, this compounds the effect that the rates have on a household level obviously but it may just be that low interest rates are not drastic enough to help change a culture that has been ingrained for years.

I completely agree with Professor Kimball in that I think it is only a matter of time before governments realize that the massive bond buying programs are pointless when you could just implement negative interest rates. These days seem like perfect days to be thinking about this idea too when things like bitcoin and dogecoin etc. – people are recognizing these alternative currencies. There are many obstacles on the road to the implementation of a monetary policy tool like this but negative rates are one of the best economic ideas I have come across.


All Eyes on Fed: From Emerging Markets to U.S. Investors

The decline in stocks last week places additional focus on this week’s Federal Reserve policy meeting, where Fed officials will consider whether to continue winding down their stimulus measures.

Last week, financial markets have undergone a large selloff of emerging market assets, an event induced by worries over weak economic data from China (a historical low of GDP growth of 7.7%), protests in Ukraine, and sliding currencies in Turkey and Argentina. Layered on top are worries that as the Fed reins in its bond buying, the flow of credit in emerging markets will be stanched.(From WSJ)

Fed’s QE has made the emerging market assets more favorable than the fixed income assets in U.S. (such as 10 yrs treasury bonds), whose yields were essentially zero over the bonds- purchasing periods. “Emerging-market leaders would appreciate it if the Federal Reserve opts against further tapering of its bond purchases this week.” (From WSJ) Now as the recent bad news of emerging market selloff appearing on the head lines of all major media, they would even more eager to see FED slow down taper. Tapering would lead to a huge retreat of money from emerging market that had help them survive through the financial crisis.

However what FED will do would not based on what foreign country would hoped. I think FED’s final decision on whether or not to further taper depends which one of the two forces discussed below will win. One force is the money that is now in emerging market. If tapering is announced, huge amount of money will surely flyback to U.S, driving down ten years treasury bonds yields. If this force is big enough, U.S. stocks market will continue the buoyancy of 2013, and housing market will also perform well in Spring sell. Another force is from local investors. If, when tapering is announced, investors from U.S. Stock market, housing markets and other risky assets react faster, or more evidence suggest that they tend to believe treasury bonds yield will not be drive down by the return of money form emerging markets, they will cash out and turns into treasury bonds buying. Thus the falling of U.S. stocks might prompt companies to grow cautious all over again.

Ultimately, which force is going to win depends not on exactly which forces is stronger, but depends on what market believe which force is stronger.

I also pondered on the effect of FED might have on China. Once tapering is announced, “hot money will flee China, which will leads to a reshuffle of the current economy situation. Since a large portion of money were invested in the housing market, the housing bubble might burst once these money retreat for safety. Shadow banking problem in China might also reached a turning point where default risk will raised as the housing market crashed down ( A huge amount of lending from shadow banks went into housing markets). But there is also good news for China if we seek opportunity out of this crisis. As rich countries recovered from recessions, export of China might restore. It is also good to see some of the hot money that caused inflation in China squeezed out of circulation.  Crashing down of shadow banks and housing bubble will be a short term pain, but will eventually bring about a more healthier economy if Chinese government seize the opportunity to carry out reforms that are long overdue.


Friday (1/24/14) Market Decline and Emerging Market Capital Outflows

On Friday (1/24/14), all U.S. indexes fell sharply. The DJIA declined 318.24 (or 1.96%), the NASDAQ declined 90.70 (or 2.15%), and the S&P 500 declined 38.17 (or 2.09%). In financial markets, movements around two percent are considered to be pretty significant. According to the Wall Street Journal, “U.S. stocks tumbled Friday to their biggest loss in more than seven months, extending a global selloff that investors fear signals turmoil to come as financial markets adjust to a pullback in central-bank stimulus”. In my previous blogs, I expressed my opinion that financial markets had fully priced in the taper and that the Fed must continue tapering in order for financial markets to remain calm. For example, the Fed’s initial announcement to taper was received well by financial markets because they were expecting it. However, Friday’s decline shows that financial markets might be thinking differently that I thought. As the FOMC approaches this week, financial markets are anticipating another reduction in Fed stimulus and this is creating concern in financial markets that have become accustomed to the stimulus.

In response to my recent revised blog post, Professor Kimball pointed out an interest fact that helps me understand Friday’s decline. Professor Kimball wrote in his email to me, “Last time the Fed surprised the markets by delaying the taper, the markets reacted to it as something quite simulative”. This is absolutely true. When the Fed decided not to taper over the summer the markets rallied significantly. Following this logic, when the Fed follows through on their decision to taper this week one should expect the markets to fall. Thanks to Professor Kimball’s insight, the decline on Friday makes more sense as it is reflecting the expectation that the Fed will continue the taper.

The Fed’s decision to taper also has implications for developing economies. According to the Wall Street Journal, “In recent years [developing economies] were buoyed by the high tide of cash from the U.S. Federal Reserve’s stimulus and by China’s voracious growth. Now, those forces are receding, with the Fed expected to reduce monthly bond purchases again on Wednesday”. Although the Fed is the central bank of the United States, its policy decisions have implications for other countries. The fact that we are living in a global economy is fascinating, however, it is also quite disturbing because a decision in one country can have far reaching effects into other countries that had no part in that decision.

The Fed’s stimulus pushed down interest rates in the U.S., which caused investors looking for a better return to invest their money elsewhere. According to the Wall Street Journal, “Shifting Federal Reserve policy could alter the tides of capital flowing through the world economy. As the Fed has pumped dollars into the U.S. financial system to boost growth at home, waves of investment money have flooded into markets overseas in search of returns that beat exceptionally low U.S. interest rates, pushing up prices there”. Quantitative easing caused many developing economies to experience sizable capital inflows because investors were searching for higher yield. Now that quantitative easing is being reversed, there will likely be capital outflows from developing economies into the U.S. (which has already been seen to some extent).

As demand falls for the securities of developing economies, problems will arise as prices fall and yields rise. According to the Wall Street Journal, “Now, as the Fed steps back, the prospect of higher returns in the U.S. promises to pull that money back in. Investors in emerging markets are struggling to figure out how much compensation to demand for their risks, especially in economies that appear weak”. Investors will likely demand higher interest rates as compensation for this risk. Higher interest rates would increase borrowing costs for developing economies, which would certainly hinder their growth and development.

Despite Friday’s huge decline in U.S. markets, the Fed’s rationale for tapering is that the U.S. economy is recovering! Furthermore, a recovery in U.S. markets does not need to be trouble for emerging markets. According to the Wall Street Journal,

Nerves are clearly running high; after so many years of economic and market turmoil, that’s hardly surprising. But growth in developed economies looks likely to accelerate this year, which should yet be a vital support for markets. Investors should keep a watchful eye on emerging-markets developments, but they shouldn’t rush to assume a new crisis is underway”.

Although emerging markets might experiences capital outflows in the short-term, hopefully in the long-term they can benefit from healthier developed economies. For example, healthy developed economies will demand more exports from emerging markets. In addition, healthy developed economies might outsource and create jobs in emerging markets. In conclusion, hopefully Friday’s decline is just indicative of a short-lived correction in response to tapering and emerging market capital outflows.

(Revised) The Fed’s Dual Mandate: The Pursuit of Happiness

The Federal Reserve (Fed) has a dual mandate, which requires maintaining maximum employment and price stability. Following the financial crisis in 2008, the worst recession since the Great Depression, the Fed assumed a significant (possibly revolutionary) role in financial markets.

Due to the sharp decline in employment and inflation, the Fed cut the federal funds rate to unprecedented lows of 0.00%-0.25%. Believe it or not, the Fed wanted to cut rates even further! Unfortunately, the Fed had reached the zero lower bound. If the fed funds rate went below zero, people would just hold cash that pays no interest rather than lend it out at a negative rate of return. Thus the Fed decided to enter uncharted territory with large-scale asset purchases known as quantitative easing (QE).

On the one hand, the fed funds rate is the short-term interest rate that is the Fed’s main conventional monetary policy tool. On the other hand, QE is intended to drive down all long-term borrowing rates and is appropriately considered unconventional monetary policy.

The logic of QE is something like this – the Fed’s buying of long-term Treasuries and mortgage-backed securities reduces supply, which causes the price of those securities to rise and the yields to fall. This also impacts the yields on other long-term securities. By flattening the yield curve, the Fed aims to stimulate many types of economic activity such as the housing market and business investment.

The Fed also uses forward guidance to create an expectation that interest rates will remain low for awhile. Forward guidance directly impacts expectations, which are immediately priced into financial markets. For example, the yield on long-term treasuries spiked when the Fed seemed to hint it was ready to taper during the summer (surprisingly the Fed chose not to taper). In their forward guidance, the Fed has indicated that the fed funds rate will stay low as long as the unemployment rate is above 6.5%.

Recently, the Fed announced its decision to cut the bond purchases by $10 billion. The Fed also signaled its intent to continue reducing its bond purchases in 2014 as long as the economy seems healthy enough. According to the Wall Street Journal, “The bond buying will be slowly reduced as long as the economy sticks to the Fed’s projection of gradually quickening growth, declining unemployment and a slight uptick of inflation from near 1% to the Fed’s 2% target“. At the time, the decision to taper was well received by financial markets. I believe this occurred for two reasons – first, tapering was already priced in over the summer. Second, the Fed’s decision was based on strong economic data. On the one hand, tapering reduces liquidity. On the other hand, tapering is symbolic of an improving overall economy.

However, the December unemployment report demonstrated anything but a recovering economy. According to the Wall Street Journal, “American employers added a disappointing 74,000 jobs in December, a tally at odds with recent signs that the economy is gaining traction and moving beyond the supports put in place after the recession”. Fortunately, many believe this number is an outlier and that it will be revised upwards.

The employment report also contained information about the unemployment rate. According to the Wall Street Journal, “The jobless rate fell to 6.7% for the month, the Labor Department said, though the decline mostly reflects job seekers giving up their search and leaving the workforce”. Although the unemployment rate is declining, the drop in the labor-force-participation rate distorts the improvement. As the unemployment rate nears the Fed’s threshold, the Fed might want to consider lowering the threshold to 6%.

While the unemployment rate is moving in the right direction (despite the fact that it is for all the wrong reasons), the other half of the Fed’s mandate (inflation) is below target. The financial markets have not really priced in the possibility of deflation (negative inflation), which would be incredibly destructive. For example, Japan was stuck in a deflationary environment for a very long time and is only just beginning to escape. Not only might the Fed want to lower the unemployment threshold, but the Fed might also want to consider implementing an inflation threshold (of maybe 1.5%-2.00%).

The Fed must demonstrate credibility in order for forward guidance to be effective. The Fed has tried to clearly express guidelines surrounding its decision to eventually raise interest rates. Keep interest rates low makes sense as long as inflation is below target and unemployment is above the Fed’s threshold.

Despite the disappointing December employment report and the low inflationary environment, Fed officials have expressed their intent to continue tapering. I think this is a good idea as stopping the taper would likely create concern in financial markets that the Fed has lost faith in the recovery.

All eyes will be on the FOMC meeting next week.