Markets watch as Bernanke hands over to Yellen

Ben Bernanke prepares to vacate his seat as Chairman of the US Federal Reserve on Friday, making way for for Janet Yellen, just as the developed economies finally seem to be coming right.

 

Yellen’s impact on the global economy will come from decisions about monetary policy – specifically the Fed’s quantitative easing program – which will be felt around the world. Markets are already jittery.

 

The Fed holds more than US$3.2 trillion in mortgage-backed securities and US treasuries, mostly purchased under its quantitative easing program introduced to stimulate the economy by massaging medium and long-term interest rates lower.

 

Already, the reaction of financial markets to this initial cut to the quantitative easing program has been to push yields on long-term treasuries higher. Share markets initially increased in a surprise following this announcement.

 

But financial markets turned last Friday, falling in anticipation of Bernanke’s final Federal Open Market Committee this week, where a decision to taper further could be taken.

 

This will be the first regularly scheduled meeting of the year, in which the membership of the committee and potential positions are decided. Economists expect a further decrease of US$10 billion in asset purchases.

 

The International Monetary Fund and the World Bank have forecast global growth at a healthy 3.2% to 3.7% for 2014. It is the first time in two years that the IMF has raised its global growth forecast.

 

In particular, those countries that experienced the most severe economic impact during and after the global financial crisis – the US, the UK and nations in southern Europe – now have better outlooks.

 

But that positive scenario isn’t without risks. The IMF also cautioned central banks in the improving economies against lifting interest rates – or decreasing money supply – too soon as their economies return to stronger growth, for fear modest inflation could turn into deflation.

 

The stark increase in money supply, in response to the global financial crisis, in key economies hasn’t resulted in the asset value increases that economic theory might predict.

 

So, lifting interest rates and decreasing money supply could result in falling asset values – which would be a problem for borrowers and could result in another peak of credit defaults, triggering an economic downturn.

 

Country-specific issues, like a moderation of growth in China, could exacerbate these problems. The IMF concludes that countries shouldn’t increase interest rates and slow down quantitative easing programs for now.

 

That puts Yellen in the spotlight in coming months. Read more ...

 

 

Harry Scheule is Associate Professor, Finance, at UTS Business School