QE is dead! Long live QE! Investec’s Wynne-Jones on tapering

Mark Wynne-Jones, Investec Asset Management’s portfolio manager on the Investec American Fund believes the Fed’s decision not to taper is motivated by a still lacklustre US economy.

Conveniently timed shortly before this month’s FOMC meeting, the Federal Reserve Bank of Kansas City published a paper looking into the ins and outs of large scale asset purchases, or Quantitative Easing. Although the authors challenged the view that QE works through broad channels such as affecting the term premium on all long-term bonds, they did argue that the purchasing of mortgage-backed securities (MBS) has had a beneficial impact on asset prices through a capital constraints channel and a scarcity channel.

The Federal Reserve’s purchases of a substantial amount of new issuance MBS created a scarcity of supply, thus suppressing MBS spreads relative to Treasury yields. This process is deemed to have had beneficial macroeconomic effects, although the only mentioned beneficiary is the housing market.

Housing market, employment still fragile

Thus it appears clear to us that the immediate strains to the housing market caused by rising long-term rates, themselves caused by Fed chairman Ben Bernanke’s talk of tapering, is the primary reason behind yesterday’s decision not to taper. With unemployment above the Fed’s target, and inflation below, the only ‘achievement’ the Fed can cling to is the recovery in the housing market. For sure, the Case-Shiller composite index of house prices is showing double-digit gains over the past year. Housing starts, meanwhile, remain at recessionary lows, some 40% below their 50-year average. After $3trn of asset purchases, one would have hoped the Fed might by now have had a little more to hang its hat on.

Not that she needed to have worried, but writing in the Financial Times, former chairman of the Federal Deposit Insurance Corporation, Sheila Bair, commented recently that ‘the US economy will be in uncharted waters when the Fed leaves it to fend for itself’. But many have argued persuasively that it has been the Fed’s – and other institutions’ – reluctance to get out of the economy’s way that is the cause of the economy’s ill health.

As any Austrian economist would argue, manipulating interest rates lower cannot stimulate the wealth generation process, it can only divert wealth from productive activities to non-productive activities (eg: real estate). It can only benefit those closest to the new money, such as the fixed income operations of investment banks, or those that are able to gain access to the lower rates (cf. the 10% rise in London house prices over the past 12 months with the 1% gain achieved outside of the South-East).

Cause for celebration?

Perhaps it boils down to a question as pretentious as this: if money printing was the panacea for economic health, why does so much of America, let alone the world, remain impoverished?

How can a medium of exchange create wealth? While the markets may have understandably cheered the outcome of yesterday’s FOMC meeting, yet more QE – flawed in itself – is only an indication that the Fed does not believe the economy can stand on its own two feet. Is that really worth celebrating?

And after a rash of positive economic surprises that failed to prevent the Fed from cutting its growth forecasts, yet again, for this year and next, the equity markets are hardly primed to withstand any negative news flow.

Fed’s fire-fighting skills questioned

It has been so often said that you should not fight the Fed, but we are not so sure. In recent history, the Fed has been unable to prevent two equity bear markets and one housing crash – we see no reason to believe its fire-fighting skills have improved. Whatever one’s views on the precious metal, gold is perhaps the ultimate Fed fighter – while the S&P rallied by 1% last night, gold leapt by 4%. It was Ernest Hemingway who said ‘the first panacea for a mismanaged nation is inflation of the currency’ – the Fed should be careful what it wishes for.

In the space of a few months, Bernanke has first mused about ending QE, sending markets into a panic, before seemingly changing his mind, sending them into fervour. While here on planet Earth, Bernanke remains lauded as a fine Fed chairman, observers from Mars might consider his actions either cunning or clueless, neither of which appear to be appropriate attributes for the world’s central banker. In the 1950’s, then chairman William Martin famously said the role of the Fed was to ‘take away the punch bowl just as the party gets going’. If anything, Bernanke appears to be doing the opposite. His is a swell party – enjoy it while it lasts.

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