THE Federal Reserve has so far done an excellent job of goosing US equities through its ongoing asset purchase programme. As Fed chairman Ben Bernanke has intimated, boosting stock prices is now one of the Reserve’s aims, on top of its officially mandated dual role of ensuring price stability and full employment. So investors were cheered by last week’s statement from the Federal Open Market Committee (FOMC). This pretty much said that there was no need for concern over the state of the economy. However, as unemployment and the housing market were still a bit flaky, the Fed would continue to reinvest the proceeds of maturing mortgage-backed securities, and buying back $600bn of Treasuries.
This quantitative easing programme is the starter-motor for Ben Bernanke’s “virtuous circle”. In theory, it should ensure long term interest rates fall, so lowering mortgage rates allowing struggling homeowners to refinance. Lower corporate bond rates will also encourage investment and this investment should lead to higher equity prices. These in turn boost consumer wealth and confidence, so spending picks up, raising incomes and profits that support economic expansion.
But even assuming this works, there are other consequences from quantitative easing. There can be little doubt that rising prices of food, fuel and other commodities have lifted inflation around the world. Also, as Japan found out last week, endlessly increasing public debt can damage your credit rating. The news that Moody’s is taking a closer look at the US has rattled investors. Government debt is soaring, while tax revenues were sliding even before the extension of the Bush tax cuts at the end of last year. Of course, if Moody’s, Fitch or Standard & Poor’s do bite the bullet with a downgrade for the US, they will only be following what China’s Dagong Credit Rating Co. told us last summer.
But the stock market gains associated with quantitative easing are as much about expectations as liquidity. The effects can be clearly seen as the New York Federal Reserve begins its near-daily permanent open market operations. Trading programmes kick in to target those equities and indices which are seen as most susceptible to the momentum trade. But there are recent signs of diminishing returns from this activity, and it may not prove to be a perpetual one-way bet. If recent geopolitical events escalate, they could end up being the trigger for a nasty downside correction.