When the Fed unexpectedly decided not to taper in September, the markets were stunned and gyrated wildly, although investors had only themselves to blame for being wrong-footed in this way. Ben Bernanke had made crystal clear his reluctance to reduce monetary stimulus as long as the US economy appeared to be weakening, which appeared to be the case throughout the summer. By December 19, the situation may well be very different, since the economy will probably be improving and the US fiscal stalemate may well have been resolved. If such improvements happen, the Fed will have no compunctions about wrong-footing investors again, in the opposite direction.
So what will be the impact on the world economy and financial markets if the Fed decided to taper as early as December The answer is, not much. As long as the Fed stands by its commitment to keep interest rates near zero for the foreseeable future, tapering will have no major economic impact. Therefore, its financial significance should also be marginal, except insofar as investor psychology overwhelms rational economic analysis.
Ever since the global taper tantrum started six months ago, I have suggested in my column that investors and business leaders should spend less time on Talmudic parsing of Fed rhetoric and more on analysing the economic and financial data that will ultimately determine the outlook for the global economy and financial markets, and therefore drive monetary decisions too. For much of this period, investors have chosen to do the opposite, swinging from panic to euphoria and back at the slightest hint of a nuance in the Feds verbal contortions. Luckily this neurotic behaviour has calmed down in the past few weeks, as investors have reverted to the focus on economic and financial fundamentals that served them well in the first few months of this year, before the taper tantrum.
This calmer behaviour is likely to continue, regardless of what the Fed decides to do on December 19, for two reasons. The first is that the obstacles to economic growth that largely explained this years disappointing performance are gradually eroding, as explained in the FOMC minutes this week: Acceleration [of the US economy is] expected to be bolstered by the gradual abatement of headwinds that have been slowing the pace of economic recoverysuch as household-sector deleveraging, tight credit conditions for some households and businesses, and fiscal restraintas well as improved prospects for global growth.
The most important headwind has been fiscal restraint, the Feds euphemism for the lethal combination of tax hikes and public spending cuts that have squeezed US economic growth by a full percentage point in each of the past four years. In the absence of this fiscal restraint, the US economy would already have returned to something like normal growth. Although US GDP growth since the end of 2009 has averaged only 2.3% annually, making this the weakest economic recovery in post-war US history, private sector growth, excluding government consumption and investment, has averaged 3.4%, close to a normal recovery pace.
Assuming that a budget deal can be agreed without imposing any further fiscal tightening in 2014and this now seems to be an aim shared by both parties Congressional leaders and the White Housethe growth of above 3% already achieved by the US private sector over the past four years should
become a reasonable expectation for the economy as a whole. Which leads to the second reason for expecting a calmer market reaction to the Feds monetary decisions.
If the headwinds to the US economy abate and GDP growth returns to a normal recovery pace of above 3%, the obsession in the business and financial community with trying to second-guess monetary and fiscal policies will also diminish. If the economy returns to normal levels of growth, anxieties about fiscal sustainability and budget deficits will be put to rest. Investors, entrepreneurs and consumers will be able to get on with their normal business, instead of worrying about abrupt tax hikes or public spending cuts.
An even bigger benefit of resuming normal rates of economic growth would be a revival of confidence in monetary policy. If Fed policy finally seems like it is achieving the results that Ben Bernanke intended and promiseddecent growth and a gradual reduction of unemploymentinvestors and business leaders will stop panicking about marginal monetary adjustments such as tapering and focus instead on the monetary policy decisions that really matter. These are all about interest ratesand in terms of interest rate decisions, both now and in the future, the Fed under Janet Yellen looks to be even bolder than the Bernanke Fed.
Not only has Yellen been more explicit than Bernanke in promising to keep US interest rates near zero long after unemployment falls below the Feds 6.5% threshold, but the FOMC is now uniting behind additional stimulus. The minutes suggested, for example, that when the tapering decision is taken it will be accompanied by a further cut in the interest paid to banks on reserves parked at the Fed. The purpose will be to underline in the clearest possible manner that tapering implies no wavering in the Feds commitment to zero rates.
In short, the outlook for monetary policy is now as clear and stable as it has ever been. Short-term interest rates will remain near zero for years aheadand this applies in Europe, Britain and Japan, as well as the US. With monetary policy around the world now set in stone, investors and business leaders can stop throwing tantrums about central bankers and get back to the serious business of deploying capital and creating jobs.