On Thursday, the president of the Federal Reserve Bank of Philadelphia gave a speech urging the Federal Open Market Committee (FOCM) to “taper” its latest quantitative easing program, “with an aim toward ending them before the end of the year”. Plosser argued that “with interest rates already extremely low and the Fed’s balance sheet large and growing, monetary policy is posing risks to the economy in terms of financial stability, market functioning, and price stability”.
Indeed, Plosser’s statement comes amidst rising concerns that the Fed may be overplaying its hand in a way that could be detrimental to the American economy. The danger, as Ben Bernanke himself explains, is that artificially low interest rates could lead to “excessive-risk taking,” as investors are driven to search for higher yields. In turn, this quest for higher yields could lead to a distortion of “asset prices and their relationship with fundamentals,” creating a bubble that could get out of control once the economy begins to normalize.
To be sure, quantitative easing has had its successes. Unemployment levels have gradually decreased over the past two years, standing at 7.5% in April; and although inflation is at an all-time low, standing at 1.1% in April (0.9% below the Fed’s 2% target), long-term expectations have remained stable. As a result, the Fed has been reluctant to halt its aggressive policy. A statement issued by the FOCM on May 1 read: “The Committee expects that a highly accommodative stance of monetary policy will remain (…) so long as the unemployment rate remains above 6½%, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2% longer-run goal, and longer-term inflation expectations continue to be well anchored.”
Yet Plosser’s speech today, and Bernanke’s cautious tone three weeks ago, seem to suggest that a stop to quantitative easing is to come soon. In fact, the Fed has already mapped out a plan for winding down its multi-billion-dollar rescue scheme. The question now is when, and how, it is going to implement this. A recent Wall Street Journal survey of private economists showed that more than half of them (55%) expect the Fed to reduce its purchases only next year, and with the latest employment figures released on Friday showing the unemployment rate holding steady, investors are anxious to see what the FED’s response will be.
In any case, the Fed has stated that any change in policy will be gradual and data-dependent. Purchases would decline over time according to how the economy is faring, not necessarily in a linear fashion. This may very well lead to uncertainty in the markets, as investors would be constantly unsure of the Fed’s next step, but it may be the only way to prevent the market from plummeting as a result of an abrupt end to the policy. Fundamentally, however, there is no perfect way out of quantitative easing, and any exit strategy put in place by the Fed, no matter how soon or how late, will certainly come at a cost.