Fed warned on tapering policy as emerging market rout deepens
The Fed should continue with its current quantitative-easing programme, given the prolonged US deleveraging cycle and downside risks to inflation and growth, warns Carmen Reinhart, economics professor at Harvard, as fears grow that the tapering of bond purchases, expected in September, will deepen the sell-off in emerging markets.
|Carmen Reinhart, economics professor
The Fed risks a substantial policy mistake if, as markets expect, it begins to taper its asset-purchase programme in September, warns Carmen Reinhart – economics professor at Harvard and one of the world’s leading experts on debt cycles – citing the stubborn disrepair of US household and fiscal balance sheets, and headwinds to growth. Minutes from the Fed’s meeting in July showed broad support for the winding down of its $85 billion of monthly asset purchases, first signalled by Fed chairman Ben Bernanke in May, while the US unemployment rate fell to 7.4% in July, the lowest level since December 2008.
In an interview with Euromoney, Reinhart warns: “We still have a great degree of deleveraging to endure in the US, and the issues around the world, particularly in Europe, are far from resolved.”
Asked about the relative emphasis of employment versus price stability in the Fed’s dual mandate, Reinhart says these objectives were “nowhere near conflict”. “At some point the Fed’s policy mandate will force it to consider a trade-off but I don’t see that yet,” she says. “Cyclically right now, where is the inflation?”
The faster-than-expected tapering timetable has re-priced global risk premia – with the benchmark 10-year Treasury note nearing 3% in recent trades – triggering outflows from fixed-income funds, with emerging market (EM) currencies, local credit and equities also bearing the brunt.
Earlier this year, dovish sell-side analysts told Euromoney they expected to see a steady steepening of the US yield curve, with the 10-year note hitting 2.9% to 3.0% by end of 2014, based on an improvement in the US unemployment rate to below 6.5%.
Reinhart says the prospect of tightening US liquidity conditions poses a debt-sustainability challenge. “The Fed probably signalled more to the markets than it intended [in recent meetings],” she says. “The communication was problematic.
“Right now, a withdrawal of stimulus would be premature. Where you have weak inflation and poor unemployment, even though we have seen better economic news recently, you have a tepid recovery.
“And in the area where the Fed has chosen to help, such as the housing, there has been a bit of a recovery but the Case-Shiller index [a benchmark gauge for US house prices] is still below its peak, so we are not there in terms of recovery.”
Asked whether the Fed should take into account the prospect of financial bubbles, triggered by its loose stance, in its policy calculations, Reinhart says there is no precedent of the US central bank conceiving of its mandate outside the objectives of employment and price stability.
“Because of the recent crisis, people are understandably more bubble-conscious than before,” she says. “There is a consensus that the Fed should continue to focus on growth and employment as its target, and it does not have a history of pricking bubbles. I don’t see why this should be changed.”
Fed vice-chairman Janet Yellen, and Larry Summers, a veteran economist, have emerged as the leading contenders for leadership of the Fed when Bernanke’s term comes to an end on January 31, 2014.
Asked to comment on the leadership debate, Reinhart says: “They are both highly qualified people. I don’t think we are going to see the same kind of need to respond to crises like we did in 2008, where there was a re-awakening of the idea that developed markets, not just emerging markets, could collapse.”
Reinhart – co-author with Kenneth Rogoff, former IMF chief economist, of an influential and contentious paper that concluded a public debt-to-GDP ratio over 90% is historically correlated with slowing long-term growth – adds: “The ideal qualities would be someone who is open to the idea of helping the deleveraging process.
“The Fed has been doing fiscal policy – a role that it did not pursue before the crisis. We don’t need anyone to reinvent the wheel – we just need the Fed chair to think creatively on policy tools that deal with deleveraging and other issues such as reserve requirements.”
Asked about the impact of tighter US monetary conditions on EMs, Reinhart - whose work on the impact of credit-flow bonanzas on EMs is influential in policy circles – says: “Emerging markets enjoyed a raft of global factors that now are very hard to replicate: low interest rates and high commodity prices, tied to the strength of China’s growth.
“This nurtured a mistaken view that emerging markets had entered a brave new world.”
She sounded the alarm on elevated real-estate valuations in many EMs, China’s “disorderly” shift to a consumption-driven model, which threatens commodity exporters, the prospect of continued outflows from EMs with deteriorating current accounts, and the fact that, from Hong Kong to Brazil, credit growth has vastly outpaced nominal GDP expansion since 2008.
Reinhart adds: “During boom cycles, there is always some form of indiscriminate lending. You don’t need foreign debt to create a banking crisis – just take a look at Japan.”