Bernanke’s faith in QE on shaky ground

         Since the end of the International Monetary Fund meetings in Tokyo less than a week ago, there have been a series of defensive statements from Federal Reserve officials trumpeting the success of their actions. Ben Bernanke, head of the US central bank, said Fed policy “helps strengthen the US economic recovery” and “by boosting US spending and growth it has the effect of helping support the global economy as well”.

         But there is little hard evidence of either a recovery in the broad economy or a connection between “quantitative easing” and any hopeful signs of improvement in the economy. The economic activity that was supposed to be sparked by the third round of quantitative easing has yet to materialise.

         Indeed, the impact of this latest round of unconventional monetary policy is already fading. Analysts at Morgan Stanley this week decided that returns in the high-yield market were no longer attractive in the face of deteriorating fundamentals. The stock market is struggling to make further headway, while yields on mortgage-backed securities have started to turn up after an initial drop. A drop in third-quarter capital expenditure suggests the Fed policy hasn’t been a catalyst for corporate investment at all.

         One major reason for the lack of effectiveness of this latest round of quantitative easing may well be agrowing concern with the “fiscal cliff”, automatic US tax rises and spending cuts due to kick in on January 1. Uncertainty over “cliff risk” – and the prospects of a deal in Congress on deficit reduction – seems to be offsetting any positive impact of Fed policies.

         Goldman Sachs this week sent its clients its fiscal risk scenarios. What it refers to as its base case (the “not so good scenario”), in which the cliff is barely resolved by year end, results in a 1.5 percentage point deduction from real GDP growth in early 2013. Under its bad scenario, in which jobless benefits and upper income tax cuts expire, that drag rises to almost 2 percentage points. Finally, under its ugly scenario, where there is no agreement on a path to more fiscal prudence for an extended period, the GDP growth hit amounts to about 4 percentage points and plunges the economy back into recession.

         Meanwhile, research from Merrill Lynch suggests that cliff risk could have a big impact on corporate earnings and lead the stock market to correct to a level of 1,000.

         Paradoxically, perhaps, the impact of cliff risk is likely to be dramatic whether or not politicians take bold action. If Congress does succeed in negotiating the deficit down to 1 per cent or 1.5 per cent of GDP from its current 4.3 per cent, the tightening impact will be significant. But if Congress fails to act, the uncertainty is equally likely to curb corporate investment and growth.

         While fears such as that over cliff risk are making Fed policy less effective, Mr Bernanke’s peers were quick to take issue with the chairman’s assumption that the Fed’s policies are essentially costless. Masaaki Shirakawa, governor of the Bank of Japan, who has long believed that monetary policy cannot do more than add incremental support to the real economy, noted that “the global easing bias may have parallels with the environment that gave rise to the great credit bubble of the 2000s”.

         Indeed, for the junk bond market in the US it is 2007 again, with the gap between frothy debt markets and a listless economy stark. The first two weeks of October saw record refinancing in both the high-yield and leveraged loan markets, with 80 per cent of that orchestrated by investment firms. That data underscores the extent to which the biggest beneficiaries of the Fed policy have been private equity firms, rather than households (especially savers) or companies.

         Emerging market central bankers are also critical of the Fed, fearing a link between Bernanke’s easing policies and a rise in commodity prices and asset bubbles in their markets. Many sympathise with Morgan Stanley’s Ruchir Sharma, who argues that quantitative easing contributes to income disparities, since the burden of rising commodity prices falls hardest on poorer people while the wealthy are the beneficiaries of rising asset prices. These central bankers, be they from Japan, India or Brazil, seem to believe more than Bernanke that there is no such thing as a free lunch.

By Henny Sender, souce:http://www.ft.com, October 19, 2012