Spooked Fed caught in a trap

In trying to fix one problem with its money-printing programme, the Federal Reserve has created another: liquidity-addicted markets.

"As surprises go, the markets loved it," says Economist.com's Buttonwood blog. Last Wednesday, the US Federal Reserve was widely expected to begin tapering' its quantitative easing (QE) programme, reducing slightly the monthly amount of various bonds it buys with printed money. But, in fact, the central bank stayed its hand. Its decision not to temper the pace of its monetary-easing policy delighted liquidity-addicted markets. America's Dow Jones and S&P 500 indices rose to new highs, and European shares reached a five-year high. Bond yields fell as prices rose and commodities ticked up.

Why the Fed hesitated

The Fed keeps an especially close eye on the unemployment figures. The jobless rate has slid to 7.3%, but only because so many people are dropping out of the workforce. The Fed wants to wait until the economy shows more signs that it can muster a sustainable recovery. It may also be concerned about the impending debt ceiling stand-off in Congress rattling confidence and activity.

But the main issue is that the Fed "has been spooked" by the sharp rise in long-term interest rates since it started hinting in May that it might taper QE, as Capital Economics points out. The yield on the ten-year Treasury, for instance, jumped from 1.6% to as much as 3% as prices slid.

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Markets began to factor in eventual rises in the benchmark, short-term interest rate, sending rates higher along the yield curve. But this in itself tightens overall monetary policy. For instance, mortgage rates are priced off Treasury yields. The average rate on a 30-year fixed mortgage rate has hit 4.5%, up from 3.5% in May.

This is undermining the housing recovery. Home loan applications, having declined in 15 of the past 18 weeks, have fallen back to their lowest level since 2008, says Bloomberg.com. Mortgage refinancing is down 70% year-on-year. Purchases of new houses notched up their biggest fall in three years in July. And all this from a ten-year yield of 3%. It would rise by far more if yields regain historically normal levels.

What next?

If higher bond yields and lower stocks are economically damaging, asks Buttonwood, "when can the Fed possibly withdraw the policy"? The implied answer is never. It looks impossible for the Fed to exit QE without triggering a recession, says Peter Schiff of Euro Pacific Capital. "The Fed has checked into a monetary Roach Motel. Getting out will be infinitely harder than getting in."

But ploughing on with QE brings its own problems. For starters, while throwing printed money at the economy may have prevented an even nastier crash in 2008/2009, it's hard to argue that it has created a sustainable recovery. Plenty of liquidity has flowed into financial markets but the broader macroeconomic picture remains lacklustre.

Meanwhile, it is blowing up asset bubbles, and the bigger they get, the more damage they can do when they burst. And the more printed money washing around an economy, the greater the odds of an eventual surge in inflation. So the Fed seems essentially stuck with a policy that isn't helping the economy and has dangerous side effects. Given all this, it's no wonder that stocks have slipped since last Wednesday. Investors have started to twig that this great money-printing experiment could end very messily indeed.