Standard Life Investments

Published Article

Investment Week - What can the fed do next?


The mountain resort of Jackson Hole has been used for meetings of central bank governors since 1978. Few have attracted as much attention as the recent speech given by Ben Bernanke, the Federal Reserve Chairman. Against the backdrop of 20% declines in share prices, safe haven flows pushing government bond yields to generational lows, and business surveys suggesting imminent recession in the world’s largest economy, what could Ben do to calm down nerves?

There are dangers with the media building up such events, making them more important than they really are. It should be remembered that the Fed made an announcement only a few weeks ago – its statement that interest rates could be on hold until 2013 was a major factor lowering US bond yields, hopefully paving the way for mortgage refinancing. Markets were rather greedy, therefore, in thinking that QE3 could follow so soon. Secondly, Jackson Hole is intended to be a talking shop for the world’s central bankers, not a policy making forum. The Fed is clearly considering what to do next but the Fed Chairman is only one member, albeit an influential one, of a large committee who currently have rather different views on the growth and inflation outlook.

With that background, how did Bernanke do? Rather well in fact. He avoided the obvious pitfalls, reassuring investors that the economic outlook was not as bad as some were making out – and if it is then the Fed will act! What is the outlook for the US economy? ‘Watch what they do, not what they say’ is a useful maxim when the data has been as mixed as seen in July and August. Certainly, business and consumer confidence has slumped after the latest market turmoil, reaching levels which in the past would suggest that the US is on the verge of recession. Dangerous times indeed. However, the hard data for spending, output, employment and investment all suggest an economy growing into the autumn, if slowly. Looking ahead, we are quietly confident: the combination of lower oil prices, lower mortgage rates and a recovery in Japan should, in our view, allow further expansion into year end.

If the US does remain stuck in first gear, what are the options facing the Fed? It is useful to compare and contrast Bernanke’s latest speech with an important one which he made back in 2002. Then, he considered how and why Japan had entered its ‘lost decades’, and what steps should be taken to prevent a recurrence. The list of available options was interesting, because the Fed is approaching the half way mark. It has adopted quantitative easing, made loans to commercial banks and, most recently, a commitment to hold the overnight rate to zero for a specified time. Number four would be Operation Twist, explicit ceilings on government bond yields, useful either to lower mortgage rates further or prevent their increase. Each additional step becomes more powerful, and more dangerous, as next would be intervening in the foreign exchange markets to depreciate the US dollar, before finally accommodating government spending programme – the infamous helicopter drop of money, deliberately creating inflation.

The Fed will meet in late September to decide on next steps, although unless data is very poor it may hold off a decision until November. Financial markets have taken the hint from Bernanke, a re-run of the famous Greenspan ‘put’ or floor to the market. If economic growth does recover, as we expect, then the Fed will hold off, while if it is too weak then central bank support will appear.

The danger with this approach though is that it continues to paper over the cracks, providing short term medicine rather than encouraging the structural reforms so needed in the US, and other economies. The US did benefit from QE1 and QE2, as lower bond yields and higher share prices supported activity. It is becoming clearer by the day though that many problems facing the US are deep seated: unemployment of 9%, 1 in 5 mortgages under water, a banking system still needing capital. All the Fed can do is buy time while economies restructure. It was interesting therefore that within a few days of Jackson Hole, Bernanke, Trichet at the ECB and Lagarde at the IMF all made similar points in speeches – exhorting governments to take the difficult decisions needed to ensure sustainable growth ahead – decisions on fiscal austerity but also on, for example, long-term education and welfare systems, infrastructure and housing markets, bank reform and regulation. The risk is that unless such reforms are pushed through voluntarily then financial markets will do it for them, in a rather more ugly manner. Add in a Presidential election due in 15 months, with all that might mean for policy paralysis, and Bernanke may have rather more occasions when he needs to try and calm nerves.

Andrew Milligan, Head of Global Strategy, Standard Life Investments

First Published 12th September 2011