Time to taper

Updated: Nov 20 2013, 08:47am hrs
Former US Federal Reserve Chairman Ben Bernanke described the Feds purchase of long-term government securities, commonly referred to as quantitative easing (QE), as portfolio-balance. The hypothesis underlying the justification of this programme was that the Feds purchases of long-term government bonds and mortgage-backed securities would reduce yields and drive savings of private investors to riskier assets class, viz equities. The demand for equities would drive up the price of equities, increase investor wealth which would finally lead to higher consumer spending, and higher GDP growththe Wealth Effect!

The current surge in the equity markets and the improved GDP growth numbers in the US has convinced the world that QE is now a necessary ongoing stimulus for the US economy to remain in high gear. Wall Street, of course, loves QE and would like to see it expand given the higher demand for stocks justified by higher DCF valuations (lower cost of capital on the denominator).

The following analysis endeavours to prove that economic growth is a consequence of factors beyond fiscal stimulus and QE was a necessary programme at the time of the crisis but to extend its role to maintain or increase GDP growth may not yield the desired results.

It is true that the drop in economic activity in 2009, the collapse of commercial lending, the fear that gripped markets coupled with tripling of the federal deficit, made QE the lifeline without which the US may have dropped into the ocean of economic depression.

Surprisingly, a study of the GDP growth data in the US over the last 80 years suggests that the US economy has the ability to revive after a recession, and even a depression, with considerable strength, with or without large stimuli. The success of the US economy perhaps lies in physical factors such as the ability of its people to work hard and innovate. The data suggests that extended intervention has strangely led to a period of indifferent and lethargic revival and the messiah of growth, easy and low-cost liquidity, has not pushed the economy to the rates of growth recorded in previous decades.

As is evident, growth has remained fairly muted in the first decade of this century for the period 2003 to 2013a decade when the Fed has followed a policy of flooding the economy with low-cost capital. History has explained the reasons for the growth in the US from 1938 to 1943, 1948 to 1953 and from 1993 to 1998. The suffering of de-growth proceeding the aforesaid decades, namely 1928 to 1933 and 1943 to 1948 and 1988 to 1993 led to a new morning. It suggests that the US economy revives after a period of lower growth and contraction to a higher trajectory of growth due to physical factors rather than fiscal stimulus. Perhaps the answer to higher and healthier growth in the US growth lies elsewhere!

One cannot undermine the contribution of QE in managing to bring a balance in the fiscal situation in the US. History will reward Bernanke with kind words for advocating and executing an unprecedented multi-trillion programme. The programme was very well-planned, well-timed and bravely executed. In the last few years, QE has brought growth in money-supply close to the average of the last three decades which has laid the foundation for an improved housing market, the root cause for the breakdown in the system in 2008-09.

The recovery has boosted sales of new and existing homes in 2012 and into 2013. The increased sales has absorbed excess inventory, steeply pushing down the months supply of homes for sale inventory.

As icing on the cake, Fannie Mae and Freddie Mac have paid back a large part of the $187 billion federal bailout the mortgage giants received, starting in 2008, to help them weather the housing crisis.

Credit card debt, another cause of considerable worry in the US, has also shown signs of marked improvement. The average US citizen is cognisant of his/her woes from credit card debt and is taking steps to de-leverage.

Per capita income of the US citizen has risen 33% in the last decade to more than $43,000 in 2013 from $32,300 in 2003. Reduced household debt, complemented with higher personal incomes, has created a strong foundation which can now perhaps grow without stimulus.

Adding the brightest colour to the painting is the resurgence in corporate earnings. Corporate earnings have not only revived but are at an all-time high, having almost doubled from the lows of 2009.

Last but not the least, the US governments finances are also improving at an exciting pace. In 2010 and 2011, it was felt that the Feds purchase of US government securities was necessary given the increase in issuance by the government and the limited absorption capability of incremental individual savings. The deficit data for 2013 is a complete reversal from the deterioration of the deficit in 2009-2012.

The above empirical data suggests that the US economy has revived, as it has in the past, and the metamorphosis is not a necessarily a derivative of the Wealth Effect. It is a hardcore development in physical growth in the economy. The fact that the economy was saved from further contraction by QE is undisputed. The patient has had his/her open heart surgery and is back home. The patient cant go jogging still, but must start walking on his/her own legswithout crutches. Given the massive heart attack, the economy will need medicines and a monthly check-up, but to maintain the same dose of medicines or a similar package of doses as prescribed in 2009 may be extremely detrimental in the medium-term.

The aforesaid endeavour suggests that Janet Yellen, the new Governor of the Fed, should consider marching ahead on the path of tapering in the months ahead. Perhaps a more effective programme from the Fed would be to keep markets guessing and leave its intent and extent of commitment to purchase government securities, at any point of time, unknown. The monthly data and sentiment should be the driving forces to determine the commitment which could be as low as nil purchases, or may I dare suggest, the Fed could turn a seller of securities.

Amit Dalal

The author is executive director, Tata Investment Corporation.

Views are personal