While the world media’s attention was focused on Glasgow and the COP26 summit, another meeting took place 3,400 miles away in Washington D.C. The Washington meeting will have a much more profound short-term impact for investors and all users of fiat money than that of Glasgow. The Washington meeting of the Federal Open Market Committee (FOMC) – the Federal Reserve bank committee that is responsible for US monetary policy – deliberated for two days and came to the well-flagged view that it should start to scale back its $120 billion per month asset purchase programme, otherwise known as quantitative easing or QE. The tapering starts.
The market had already pencilled-in a ‘tapering’, or a reduction in this massive money injection, of $15 billion per month, meaning the QE programme will end by mid-2022. At the start of December the ‘tapering’ will tighten further; just $60 billion in treasury bonds and $30 billion in agency mortgage-backed securities.
The FOMC said it was “prepared to adjust the pace” of the tapering process “if warranted by changes in the economic outlook,” adding that the remainder of the bond-buying programme would “foster smooth market functioning and accommodative financial conditions” to “support the flow of credit to households and businesses”.
Abrupt actions to tighten monetary policy have been adopted by the Reserve Bank of Australia and the Bank of Canada. The Bank of England surprised everyone by not raising interest rates on Thursday this week, despite inflation (the consumer prices index, the government’s referred measure) now at an annualised 3.1%, 1.1% above the Bank’s target. Investors are betting that the European Central Bank (ECB) could raise rates next year despite recent pushback from its president, Christine Lagarde.
For those who don’t recall how or why the US Fed started making its mammoth monthly asset purchases – it’s an uncomfortable memory so your amnesia is entirely understandable – it’s a bit of a tangled history.
The scheme was put in place in 2020 in the US to support the economy through the Covid-19 economic downturn. Japan has been doing QE for more than a decade; Sweden started its QE in 2015; Switzerland in 2013; the UK since 2009, the European Central Bank the same year. All these countries adopted QE because they feared deflation – they injected huge amounts of fiat currency into their economies to stoke inflation, in the belief that a dose of it would reverse a deflationary trend, stimulate demand, and thus economic growth.
So shortly after Covid-19 broke out in the US, the Fed pledged to buy $120 billion of Treasury bonds and agency mortgage-backed securities each month until it had seen “substantial further progress” towards average inflation of 2% and maximum employment. “My own view is that the ‘substantial further progress’ test is all but met,” said Jay Powell, chairman of the Fed, said towards the end of September.
We’ve been here before. In November 2008 the Fed started buying $600 billion (£440 billion) in mortgage-backed securities. By March 2009 it held $1.75 trillion of bank debt, mortgage-backed securities, which rose to $2.1 trillion (£1.54 trillion) by mid-2010. Since then the Fed has done three further rounds of QE. On 19 June 2013 Ben Bernanke, the then chairman of the Federal Reserve, tried to end QE3.
He said then that the Fed could scale back its bond purchases from $85 billion to $65 billion a month and suggested that the bond-buying programme could wrap up by mid-2014. While Bernanke did not announce an interest rate hike, he suggested that if inflation achieved a 2% target and unemployment decreased to 6.5%, the Fed would likely start raising rates. The stock markets dropped by approximately 4.3% over the three trading days following Bernanke’s announcement, with the Dow Jones dropping 659 points between 19 and 24 June. As for gold…over eight trading days after Bernanke’s words gold collapsed 13.4%. Gold had its worst quarterly performance in 93 years.
The nasty markets’ response to the proposed ending of the QE programme was enough to make the Fed hold off reducing its asset purchases. In December 2013, it said would begin to taper its purchases in January 2014; purchases were eventually halted on 29 October 2014. By then the Fed had accumulated $4.5 trillion in assets. As of 20 October the Fed’s assets stood at $8.5 trillion (£6.22 trillion).
What was once unconventional is now ordinary. This sustained expansion means that the Fed’s balance sheet (and those of other central banks) has become more exposed to market developments: a fall in the value of foreign assets or a rise in long-term interest rates could reduce the value of their assets while leaving the value of their liabilities intact. At some point, the capital of the central bank could be put at risk.
And yet the Fed, like central banks everywhere, is caught between the devil and the deep blue sea. It needs to push up interest rates, if only to show it is willing to quash inflation. But to do that risks knocking the wider post-Covid economic recovery for six.
Unlike 2013, when the bond market threw a tantrum at the mere mention of a taper, this announcement by the Fed that it’s ending QE has so far escaped causing a tantrum. Treasury yields ended the day higher, but the move was more pronounced on longer-dated maturities that are more sensitive to inflation expectations. The yield on the benchmark 10-year Treasury note ended the session back above 1.60% for the first time in a week, while the yield on the 2-year Treasury note, a proxy for Fed interest rate expectations, ticked fractionally higher to about 0.46%.
Perhaps the calm is deceptive and owes more to a persistent refusal to raise interest rates; the Fed’s chairman, Jay Powell, repeated his ‘inflation is transitory’ message, and that the Fed will stay patient and wait for more job growth before raising interest rates.
This is risky. Inflation in the US is likely to hit 6% – it’s been running at twice the Fed’s annual 2% target for the last five months. The Fed’s benchmark overnight interest rate is near zero. “We don’t think it is time yet to raise interest rates. There is still ground to cover to reach maximum employment,” said Powell on Wednesday this week.
The political context
Monetary policy in the US cannot be separated from political life, which remains as divisive as ever. The Republican, Glenn Youngkin has just been elected the next governor of Virginia, which will have sent shivers down the spine of President Joe Biden.
According to a commentary by Charles Lipson, emeritus Professor of Political Science at the University of Chicago: “on a national level Democrats have delivered only failure: inflation, onerous mandates, empty store shelves, racially-divisive school lessons, and a humiliating withdrawal from Afghanistan.” Kamala Harris, the US vice-president, said last week before the Virginia vote “What happens in Virginia will in large part determine what happens in 2022, 2024 and on.” Democrats now fear that she was distressingly correct.
Biden wants to push through Congress a $1.2 trillion (£880 billion) infrastructure package and a revised $1.75 trillion (£1.28 trillion) ‘build back better’ plan investing in childcare, public health and climate initiatives. But Congress is paralyzed and Biden is facing a widespread backlash in the mid-term elections next year and a fresh Presidential election may see the return of Donald Trump. Biden’s dreams may already be dust.
Implications for gold
History never repeats exactly, and the ending of QE in the US looks like having a very different impact on gold than in 2013. Gold-futures speculators have already done large amounts of selling in anticipation that the Fed will start tightening its loose money policies. The gold longs are relatively low and the shorts relatively high. This bearish positioning slashes the odds of a big gold sell-off on the latest tapering move. And the background context remains deeply uncertain. When the US starts to raise interest rates – probably not before mid-2022 at the earliest – the US Dollar will strengthen relative to other currencies. But it will still have lost around 5% of its purchasing power, thanks to inflation. Historically, gold has endured through thick and thin. The value of fiat currencies everywhere is being eroded by inflation; it’s time for an alternative form of money – gold.
At Glint, we make every effort to demonstrate a balanced conversation between gold, crypto and fiat currencies when it comes to purchasing power and, while we strongly believe that gold is the fairest and most reliable currency on the planet, we need to point out that it isn’t 100% risk free. While we have seen a steady increase over time, the value of gold can fall, which means that its purchasing power can also decline.
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