A quiet exit from a noisy world

By G.I. | WASHINGTON, D.C.

After presiding over the Federal Reserve for eight of the most turbulent, crisis-wracked years in its history, Ben Bernanke no doubt hoped to leave on a dull note. It is not to be.

Today was the Fed’s last policy meeting with Mr Bernanke as its chairman, and it did exactly as expected. It reduced its pace of monthly bond buying by $10 billion per month, to $65 billion: $30 billion of mortgage backed securities, and $35 billion of Treasurys. This was the second such tapering since the process began in December.

It also reiterated its intention to keep its short-term interest rate target close to zero “well past the time” that unemployment has declined to 6.5% (it is currently 6.7%). The statement issued after the meeting changed little from December, and what did change went in an upbeat direction: economic activity “picked up in recent quarters,” and “household spending and business fixed investment advanced more quickly in recent months.”

This decision made sense given the Fed’s forecast of growth that will accelerate to 3% this year, unemployment that drifts down, and inflation slowly edging back to its 2% target. Yet even as the Fed voted on a policy for a world that, on paper, is getting steadily better, the world outside its doors seemed to be going to hell. Global shares, led by emerging markets, have been under pressure for weeks now, and American equities were off sharply before the meeting. Some investors hoped this would give the Fed a reason to rethink its tapering. But the Fed's benign forecast and the belief among its officials that the marginal benefit of quantitative easing is going down as the marginal cost goes up has set quite high a bar to such a pause. When it became clear the bar had not been crossed, the selloff accelerated.

Of course, the selloff is not all about America: flaws of governance and policy have been gnawing away at many emerging countries for years, notably Turkey, Venezuela, Argentina and Russia. But investors overlooked those problems until the rich world began to withdraw the morphine of easy money. As my colleague R.A. notes, “Fed tightening cycles have consistently generated capital flow reversals over the past 30 years,” an observation well documented in great detail by the IMF.

It is surprising is that asset markets are responding now to a process the Fed telegraphed months ago and then executed as promised, especially after the first inkling of tapering triggered a pullback last summer. But perhaps it should not be: another colleague, P.F. notes, “Crises have a habit of coming in fits and starts … rather than in one big bang.” More than a year elapsed between Thailand’s devaluation in 1997 and Russia’s default in the summer of 1998. The response this time does seem acute given the reversal of the Fed's monetary stance has been so gradual. Indeed, Mr Bernanke would argue it has not reversed at all: the Fed is buying fewer bonds per month, but as long as it buys more than zero, its balance sheet continues to grow. And interest rates, judging from the guidance last updated in December, won’t rise until late next year. The upheaval is simply a reminder that shifts in liquidity are felt not just through interest rates, but in risk appetites. Tapering has shrunk how much risk investors will tolerate, and the result has been a massive rerating of all asset classes. This is why Treasury bond yields have gone down, instead of up: the effect of tapering has been more than offset by the demand for safety.

It gives foreigners conniptions that the Fed can cause them so much economic distress yet never take that into account when it alters policy. Well, not quite never: there are two exceptions. One is when the decline in markets represents a systemic crisis, as in 1998. Then, amidst the carnage of the Russia default, Alan Greenspan declared, “It is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress.” Rate cuts soon followed. The other exception is when the decline in markets foreshadows a slowing in economic activity.

Neither condition has been filled – yet. The fundamentals of emerging markets are better than in 1997-98, and investors are already differentiating between economic delinquents like Argentina and model students like Mexico. Yet panics have a way of both steamrolling fundamentals, and exposing flaws in those fundamentals. In 1994, it was the extreme leverage embedded in Mexico’s dollar-linked borrowing; in 1997, the parlous state of Korea’s currency reserves and its banks’ dependence on short-term dollar funding. This time around the faultline may be emerging market corporates which have happily levered up in recent years.

Meanwhile, equity markets may have caught wind of some troubling signs for America's recovery. Reports on new home sales, durable goods and employment for December were all weaker than expected. January employment, due next week, will tell whether December was an anomaly or the start of a new, weaker trend. If it’s the latter then the transition to Janet Yellen, who succeeds Mr Bernanke on February 1^st, which was widely forecast to be uneventful, will be anything but.