US Federal Reserve at Crossroads – Now or Later, Monetary Policy or Fiscal Policy

Category: US Federal Reserve August 30, 2012 | Comments Off Share
US Federal Reserve

US Federal Reserve at Crossroads

Federal Reserve Chairman Ben Bernanke’s expected announcement of a QE3 may have been Factored-In by the Equity & Commodity Markets a bit too soon, even before Bernanke has uttered a word. Markets may get disappointed since the US Federal Reserve may “Strike Only When The Iron Is Hot.” The small but steady declines in the Equity & Commodity Markets, since Tuesday seem to point out that the markets may have realized this by now. As the realization penetrates deeper, declines & market movements may get more volatile. Commodity Markets project a mildly bearish posture for Gold, Silver & Crude Oil for a couple of days.

Federal Reserve Chairman Ben Bernanke may be at cross roads, debating whether they need to give in to act in advance of a possible fiscal drag as per market expectations & boost the Economy now or to simply maintain a ready stance, just in case something bad happens and they are needed to step into the markets and stabilize things with a Big Monetary Infusion. He would also need to consider if the benefits of further accommodation outweigh the costs.

Federal Reserve QE3, an Assured Future Event:

The much anticipated & discussed Federal Reserve QE3 is anyway, an Assured Future Event with US Unemployment above the Federal Reserve’s target rate but inflation favorably below. But only those anticipating a strong signal that QE3 is in for an early September show may be sorely disappointed. The Federal Reserve may certainly want to keep the biggest ace up the sleeve & maintain a ready stance, just in case the Economic scenario worsens and strong action is needed further down the road. Bernanke may outline what the Federal Reserve has done to help stimulate the economy so far, & further at most discuss a roadmap & also provide a little bit of more information on what would trigger them to act, if & when time calls upon. That is just what the Fed has been hinting, all the while repeating, “We will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed.” The worsening European crisis & a slowdown in China may surely be a point of concern for the Federal Reserve currently, But I think Bernanke may want to wait & watch how the EU leaders tackle the burning issues of the Debt ridden Eurozone with the coming ECB policy meet on Sep 6th, & also since China is expected to infuse some kind of easing in the next few days. ECB President Draghi is likely concentrating on the Sep 6th ECB policy meet & the Sep 12th German constitutional court decision regarding Germany’s part in the bailout of the Eurozone. After having known the details of both these crucial announcements, the US Federal Reserve will have a better understanding of the EU’s latest efforts. The August US employment report coming in the first week of Sep would also be a key factor for the Fed in analyzing the need for a QE3. The Federal Reserve, after having all facts, data & figures would then also have an opportunity to lay out a strategy & may use the same optimally, to make changes (If required) on Sept. 13 at the FOMC meet if New Changes do occur. Draghi’s cancellation of attending the Jackson Hole Symposium also raises expectations that he could make a big announcement at next week’s monthly ECB – European Central Bank meeting slated for Sep 6.  In an article published in German’s Die Zeit newspaper, ECB President Mario Draghi said that the central bank needs to employ “exceptional measures” with monetary policy, while acting within its mandate. Reports suggest China’s central bank is looking to inject more liquidity into the country’s banking system, in order to stimulate economic growth. European actions to contain the sovereign debt crisis & US Economic data leading up to the upcoming September FOMC meeting could determine what the Fed actually does. The chances of QE3 will rise significantly & swiftly on a weaker than expected employment number. The Gold, Silver & other Financial Markets remain subdued ahead of these key events.

US Economic reports released over the last month have shown improvement. The US economy seems to be moving ahead, only just not at the speed that everybody wants and financial-market conditions are not as bad as in 2010 when the Federal Reserve last undertook QE. Most economists suspect Federal Reserve Chairman Ben Bernanke won’t yield to pressures for Fresh Easing yet, in the way of signaling that QE3 is imminent. Bernanke is most likely to keep his tone & stand unchanged when he speaks at an annual Federal Reserve symposium in Jackson Hole on Friday. A fairly larger number of FOMC members favored further easing if the economy does not improve substantially fairly soon, led to the upside momentum in almost all markets last week, including precious metals, particularly ahead of Jackson Hole since Bernanke used this gathering to signal a second round of quantitative easing back in 2010.

Times have changed & so will the usage of Monetary & Fiscal Policy Tools:

The US Federal Reserve’s Jackson Hole Symposium has raised market expectations as it was here two years ago that Ben Bernanke signaled the second round of easing which gave rise to a massive asset market rally across the board. It is important to understand that the presidential campaign gaining momentum & heat close to elections, may keep the Fed in Silent mode. The Fed has always been alert & quick to respond to any Major Economic Weaknesses, but the markets are getting to a point where the US Fed’s response is just not enough to push the economy much further ahead on it’s own steam. There has to be some sort of a consolidated effort. The same kind of earlier efforts implemented today, will not be much beneficial as were two or three years ago. Higher Interest rates & bond yields in 2010 allowed the Fed more room to maneuver & have a higher impact out of its monetary infusions. Fiscal Policy & not Monetary Policy may be the need of the times as being observed in many nations now & Bernanke aptly has repeatedly called the Congress to help revive the economy. Monetary Policy changes or Quantitative Easing is surely not going to bring down the Un-employment. Manufacturers are reducing production, thereby reducing employment, due to a global slowdown & a slump in exports all around. Lower Interest rates also are not an attractive factor, with most companies being flush with funds.

Effective Economic Tools – Monetary Policy & Fiscal Policy:

For traders not coming from a background of Economic studies & to help them understand in a simple form, the functioning & the impact of these 2 powerful tools, let me try and make a distinction between these terms. Both, Monetary Policy and Fiscal Policy are used to regulate the economy, that is, to either increase or decrease the pace of economic growth to some extent. The vital difference is in the situations & methods of how they are used.

Monetary Policy: Monetary Policy is a tool that is used by the Central Bank (in case of India, it is the RBI – Reserve Bank of India) and they do this by way of regulating the interest rates. If the need is to stimulate the economy and to increase GDP growth, the RBI would cut interest rates. But if inflation is getting sticky and troublesome, the RBI would raise interest rates, so that the economy cools off and inflation comes down. Here, one needs to understand that an increase in GDP growth rates is accompanied by inflationary growth.

To get a better conceptual understanding one would need to imagine “interest rates” to be the brakes and the “economy” the car. When the car goes too fast, brakes are applied and the car slows down and when the car slows down too much the brakes are released and the car gathers speed. So in that sense, interest rates are like the “brakes” in the hands of RBI.

Fiscal Policy: While Monetary Policy is the tool in the hands of the Central Bank to regulate the economy, Fiscal Policy on the other hand, is the tool in the hands of the government to regulate the economy. So, if the government wants to help the economy to speed up, it may decide to reduce taxes so that people have higher disposable incomes to spend on goods and services. This naturally would lead to an increase in demand and supply and thereby stimulate all the interlinked industries.

Secondly, the government may also decide to increase its own spending by way of building infrastructure such as airports, railways, bridges and roads. There are several ancillary sectors that get impacted the moment the government decides to increase its spending. The demand for the production of organizations operating in these sectors increases bringing profits and prosperity. On the other hand, if the government decides to slow down the economy because of “running away” inflationary growth, it will do the opposite by way of increasing taxes and decreasing its own spends. So, yet again, Fiscal Policy is similar to brakes in the hands of the government just like Monetary Policy is the brakes in the hands of the Central Bank.

Therefore, to regulate the economy, both the government and the central banks need to work in tandem and in a balanced fashion in order to balance growth and inflation. The end objective of every government is to increase growth and decrease inflation. Various permutation and combinations of monetary policy and fiscal policy need to be applied to get the optimum results.



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