Last night the US Federal Reserve announced that it had decided not to reduce its stimulus programme (known as Quantitative Easing). It will therefore continue to intervene in the markets by purchasing US$85 billion of bonds each month.
This has widely been portrayed as a surprise in the media as the consensus expectation had been that the Fed would begin to taper down the level of support, though a significant minority of strategists and economists were not of this view. As result of the surprise, there has been a sharp reaction in the markets. Risk assets generally have responded positively in the immediate aftermath and the US stock market has reached a record high.
In the short term we believe this news will take some of the recent pressure off emerging markets, commodities and gold. These assets classes have suffered from expectations that a reduction in the Fed’s programme would result in the US dollar strengthening. Those fears should now abate, for now.
Whilst the short-term fillip to markets is clear, our view is more one of disappointment than surprise; we believe that this could be the point at which history records the Fed losing control of monetary policy.
In making its decision the Fed continues to cite the ‘elevated’ unemployment rate and below-trend inflation as critical indicators of economic performance. Adopting this dovish stance is evidence that the board members clearly do not see a positive structural shift in labour force participation rates (which indicates a poorer situation than the headline ‘unemployment rate’ implies), and that they do not appear to be concerned that stability in the markets could be threatened by continued asset price inflation.
Of less surprise but perhaps more significance was the detail in the accompanying statement. Here the Fed continued to stress that their actions will only be guided by economic data, not market expectations. In particular the committee has restated that the interest rates will remain at exceptionally low levels long after the asset purchase scheme has ended and will probably not rise until the unemployment level has hit its 6.5% target.
New Fed forecasts for the economy suggest that committee members have been consistently disappointed by the speed of recovery and have nudged down their expectations for GDP growth for both this year and next.
Significantly the majority of the committee now expects base rates to remain unaltered into 2015 and to remain at or below 2% out to the end of 2016.
Is this a mistake?
Taken in isolation the economic data is sufficiently uncertain to justify the decision not to taper; however in the context of the guidance given over the summer and the very sanguine response from investors, the decision looks to be a missed opportunity to begin weaning the economy off QE with relatively minor repercussions.
There is sufficient doubt over the accuracy of the US unemployment data to question whether rigid targeting of this measure of performance is valid at all, while more traditional measures of inflation fail to capture the undoubtedly dangerous impact of asset price bubbles that appear to be building.
With the US banking system in robust health and willing to extend credit there is a growing risk that this last point will be the ultimate deciding factor in future policy decision, rather than inflation or employment. If the Fed’s policy prolongs unsustainable asset price inflation to promote economic activity, the recovery will be built upon the same foundations that collapsed so spectacularly with the banking crisis of 2008.
What does all this mean for Investors?
While in the near term we expect riskier assets to respond well to this news, especially those markets that have suffered from expectations of dollar strengthening (emerging markets, commodities and gold) ultimately a reduction in QE will come. In our view US equities look expensive and emerging markets and commodities will continue to face headwinds over the medium term from the slowdown in China.
In our view it is important for long-term investors not to lose sight of fundamentals or get distracted by the short-term noise from this announcement into making major adjustments to their portfolios on the back of it.