Best of policy options: What Bernanke's masterstroke has achieved

By deflating potential asset bubbles - which he had long been accused of inflating - while leaving Fed officials with sufficient policy options to either add or take away from the asset purchase programme, Bernanke has secured for the Fed the best of policy options.

Vembu June 21, 2013 15:12:59 IST
Best of policy options: What Bernanke's masterstroke has achieved

Only when the tide goes out do you learn who's been swimming naked. That bit of wisdom from legendary investor Warren Buffett has been validated over the past two days by the colossal crash-bang of markets around the world - and across the board - following US Federal Reserve Board chairman Ben Bernanke's comments hinting at an early end to the monetary stimulus program in the US.

Virtually every market - from stocks to debt to commodities to currencies - has been thrown into turmoil (and shown up to be buck-naked) after Bernanke offered what was widely interpreted as the nearest thing to a deadline for the beginning of the end of the US Fed's programme of purchasing Treasury bonds to inject liquidity.

It was that programme of Quantitative Easing that had, ironically, inflated asset prices in recent years. And yet, with a few well-chosen words, Bernanke conveyed that Fed officials were sufficiently well pleased with the recovery path of the US economy and unemployment data to consider a "tapering" of the asset purchase program - and perhaps even wind it down by next year.

Best of policy options What Bernankes masterstroke has achieved

Reuters

The markets, who had gotten so used to the liquidity pumped in by the QE program of recent years, have responded with alarm. Their responses is not unlike that of a desperate junkie who finds that the drug peddler, who had kept up a steady stream of psychotropic substances, had overnight acquired religion - and threatened to cut off the supplies.

But in fact, Bernanke has given himself sufficient elbow room to keep the program for the purchase of Treasury bonds going if the US economic data or the unemployment numbers don't bear out the promise of a recovery. Bernanke indicated that the asset-purchase programme would be ended only when the US unemployment rate fell to 7 per cent, which the Fed expects will happen by the middle of next year. Until such time, the pace of asset purchases can be stepped up or slowed down, depending on the economic data.

That is precisely as it should be. Quantitative Easing was intended to stimulate the economy at a time when the central bank no longer has the leverage of low interest rates to revive the economy. And while it must be withdrawn at some point, allowing the economy to find its feet, the timing of the exit must be carefully calibrated to ensure that it doesn't happen too soon or too late.

But if Bernanke wanted the option to stimulate the economy, why then did he set off panic attacks by suggesting that the Fed would begin withdrawing the stimulus program as early as this year?

Writing in the Financial Times, John Authers offers one plausible explanation. He points out that the waves of liquidity that the US Fed had sent sluicing around the world had driven up asset prices, most egregiously in emerging markets, beyond reasonable valuations. And fears were growing that if the Fed was slow to wind down its easing, it would lead to the build-up of bubbles, which would then burst with catastrophic effect.

Thursday's sharp sell-off, which continued into Friday in many markets, revealed that there was indeed plenty of froth in the markets, observes Authers. Today, he reckons, there is less of a risk of such a bubble blowing up in everyone's face. On the other hand, Bernanke has still the option of stimulating markets. "If unemployment does not fall or inflation rise as hoped - both real risks - (the Fed) need not follow its own timetable."

Of course, it will still take considerable skill and consummate timing to engineer a smooth exit from the Quantitative Easing program. Opinion is divided among those who believe that it is entirely possible, and those who reckon that there are too many uncertainties and political factors that could mess it up.

Those who believe it can be done point out that the Fed does not need to do anything actively - such as sell securities - to find an exit. As this report notes, the Fed merely needs to stop buying anything more. "If it duly sat on its hands, the two trillion dollars worth of assets it has recently accumulated on its balance sheet would automatically roll off (that is, come to maturity), enabling the Fed balance sheet to return to pre-crisis levels over the course of the next seven to eight years. "

In any case, by deflating potential asset bubbles - which he had long been accused of inflating - while leaving Fed officials with sufficient levers to either add or take away from the asset purchase programme long after he steps down as chairman, Bernanke has secured for the Fed the best of policy options.

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