Imagine if everyone had simply taken Ben Bernanke at his word when he said in May that the Fed would continue buying bonds at the rate of $85 billion every month until it was absolutely confident that unemployment was on the way to 6.5% and that the scale of these purchases would only be increased or diminished if and when a change was clearly warranted by economic statistics. Investors would then have concluded, as I suggested at the time, that no significant changes in US monetary policy were likely until the end of 2013.
Stock markets around the would have enjoyed their strongest year for a decade without the trauma of the spring and summer taper tantrum. Nobody would have been shocked or embarrassed by the September surprise, when the Fed very sensibly decided to keep up the pace of monetary stimulus in the face of lacklustre economic figures, despite the howls of indignation from analysts who were wrong-footed by their own unsubstantiated predictions of early tapering. Finally, investors would have been fully prepared for the Feds decision to go ahead with tapering this week. After all, the recent strong run of US employment, housing and production data provided exactly the sort of strong economic background that Bernanke had posited all along as the necessary condition for tapering, especially in conjunction with the Congressional budget deal that was ratified by the Senate at the same moment Bernanke as spoke across town.
Which brings us to the implications of this weeks momentous events in Washington for economic and financial prospects. For the US economy, the combination of Fed tapering and overwhelming support in both houses of Congress for the budget deal is unambiguously good news. The uncertainties over monetary and fiscal policy that have dominated business, consumer and financial sentiment since the 2008 financial crisis are now essentially resolved. The budget deal virtually guarantees stability in both taxes and public spending until at least 2015 and probably until the next president is inaugurated in January 2017. Meanwhile, the addendum to the Feds tapering announcement, which promised to maintain interest rates at their present level until well past the time that unemployment declines below 6.5%, virtually excludes any possibility of monetary tightening until well into 2015 and represents a much stronger and clearer commitment to near-zero interest rates than anything previously heard from the Fed.
Most importantly, the Fed has now made absolutely clear and unambiguous the two key messages that Bernanke spent this year trying to explain to the markets. First, that a gradual slowdown in the Feds asset purchases does not imply any chance in the outlook for interest rates and the Fed will ensure that short-term rates remain firmly anchored near zero. Second, that US interest rates will only start to rise after the US economy has been restored to something approaching full employmentand given the millions of discouraged workers who have recently dropped out of the labour force, the restoration of full employment is likely to require several years of rapid growth, at well above the US economys long-term trend growth rate.
Thus, US monetary conditions are now virtually guaranteed to remain extremely stimulative until after the economy has achieved a long period of above-trend growth. This means that, before the Fed even starts to think about an increase in interest rates, US GDP will have to grow by around 3.5% to 4% for at least a year or two. This may sound wildly ambitious, compared with the past four years 2.4% average growth rate. But actually 3.5% to 4% growth is a very modest objective. In fact, the US private sector, excluding the effects of government spending cuts, has already been growing by an average of 3.4% since late 2009. Total GDP growth has been a full percentage point lower because of the effect of government spending cuts. But with the political clamour for public spending cuts now subsiding, even within the Tea Party, US fiscal policy has shifted into neutraland fiscal neutrality brings 3.5% to 4% GDP growth well within reach.
For US economic activity and employment, therefore, the combination of Fed tapering, budget stability and the Feds unambiguous commitment to zero interest rates looks like very good news. For financial markets, there is more ambiguity, as always, even if the US economy accelerates as described.
Stronger US growth will put upward pressure on long-term interest rates, even if the Fed keeps its promise to anchor short rates at or near zero for the next several years. Even though a large part of the upward adjustment in long-term interest rates has probably already happened, bonds and other fixed-interest securities are likely to suffer to some extent as the economy accelerates. This will create something of a headwind for equities and property prices, although history shows that during economic upswings, the benefit to equity prices from stronger economic activity and revenue growth normally outweighs the pressure from rising long-term interest rates.
A second challenge for financial markets is that Wall Street, the most obvious beneficiary of stronger US economic activity, is now the worlds most expensive stock market. Because accelerating US growth is likely to reinforce a global economic recovery, equities in Europe and Asia, many of which are still priced for economic stagnation, could well outperform Wall Street, where a fairly strong economic recovery may already be in the price. If this happens, then the Fed will be confirmed yet again as the worlds central bank.