The World Is Not Ready Yet For A Fed Taper

On the afternoon of 19 June, speaking at a press conference in the US, Federal Reserve Chairman Ben Bernanke said the central bank could begin to reduce its asset buys later this year if the US economy continues to improve, as Fed officials expect it to, and could end its purchases by mid 2014.

Eeconomic data from the US shows the world's leading economy is improving. The US may be ready for a cutback in quantitative easing (QE), but the rest of the world is not.

William H Gross, who heads the world's biggest bond manager Pacific Investment Management (Pimco), opined the Fed's (current) plan may be too hasty, while British journalist and author Matthew Lynn wrote in a column that the rest of world has real reasons to worry if and when the Fed begins trimming its bond-buys.

The Fed's massive $85bn a month bond-buying program has stimulated the US economy and the markets the world over for a while now.

Gross said the Fed has a clouded view of the US economy and its inflation. The Fed's views on the economy do not consider the fact that 'wages continue to be dampened by globalization. Demographic trends, notably the aging of (the American) society and the retirement of the Baby Boomers, (would) lead to a lower level of consumer demand. And (that) technology continues to eliminate jobs as opposed to (creating) them."

Bernanke's comments last week did not include the aforementioned factors which Gross believes will prevent American unemployment from reaching the 7% threshold in 2014, thwarting the Fed's plans to roll-back QE next year.

Bernanke expects inflation to progress towards the Fed's 2% objective "over time". 'At the moment, we're nowhere near that," Gross said.

'The Fed's plan strikes us as a bit ironic because Bernanke has long-standing and deep concerns about deflation... He badly wants to avoid the mistake of premature tightening, as occurred disastrously in the 1930s. Indeed, on several occasions during his press conference, Bernanke conditioned his expectations of tapering on inflation moving back toward the Fed's 2% objective,' he said.

British journalist Lynn refers to Bernanke as the central banker to the world.

A cutback in QE would raise bond yields in the US, which in turn would raise eurozone rates and suck out money from emerging markets, Lynn said. Rate increases in the US would push up the cost of money in Europe. US bond yields set the benchmark for the cost of money around the world.

'The trouble is, some countries cannot afford that.'

Higher interest bills may well push both Italy and Spain right back into a full-blown crisis. A sudden withdrawal of foreign funds from emerging markets can be catastrophic, as was the case during the Asian and Russian financial crisis of 1997 and 1998 respectively.

So while the American economy improves, financial chaos across Europe and Asia would spell bad news for the US, hinting that the rest of the world is still not ready for a Fed QE taper right now, Lynn said.

"Based on the chairman's comments and our (US) unemployment rate forecast, we now expect a reduction in the pace of asset purchases to $70bn a month at the September meeting ($35 billion in Treasuries and $35 billion in agency MBS)," Dean Maki, the chief US economist at Barclays said last week.

"Based on our outlook for the (US) unemployment rate to fall to 7.0% in Q1 14, we expect asset purchases to be concluded by March 2014, a bit earlier than the mid-2014 expectation the chairman indicated in the press conference," Maki said.

However, most investors seem to be getting it wrong, opined Lynn. 'Whether we see significant tapering doesn't depend on the US economy - it depends on Europe and Asia. And that means it is not going to happen, at least not in any significant way, and certainly not as fast as anyone thinks.'