The road back to normal starts now.
Royal Bank of Canada's top U.S. economist, Tom Porcelli, says it's a "foregone conclusion" that U.S. Federal Reserve Board chairman Ben Bernanke and the rest of the policy-setting Federal Open Market Committee will this week chart a course to end their third extraordinary bond-buying program since the financial crisis.
Most Wall Street analysts agree. The bet is that the Fed will trim its monthly purchases of Treasuries and mortgage-backed securities – bought with newly created money under the strategy called quantitative easing, or QE – to something like $75-billion (U.S.) a month from $85-billion.
Baby steps are necessary because the U.S. economy still is finding its legs, five years after the collapse of Lehman Brothers Holdings Inc. triggered one of the most devastating recessions on record. Gross domestic product grew at an annual rate of 2.5 per cent in the second quarter, but likely slowed to less than 2 per cent over the summer as mediocre hiring failed to outweigh the effects of weaker trade and factory production.
The disappointing third quarter could force the Fed this week to downgrade its June forecast of growth of between 2.3 per cent and 2.6 per cent this year. Same goes for inflation, which the central bank in June foresaw staying within a range of 0.8 per cent to 1.2 per cent – well short of the Fed's target of 2 per cent.
Reducing monetary stimulus, no matter how moderately, would cause cognitive dissonance for some.
Slower growth and tame inflation typically is a reason for central banks to cut interest rates, or at least leave them unchanged. For this reason, economists at Merrill Lynch think the Wall Street consensus is wrong. Michael Hanson, the bank's U.S. economist, advised clients on Friday that the Fed decision will be a "toss up," and that Merrill Lynch was sticking with its prediction that policy makers will leave their QE program alone until the end of the year.
The argument for waiting is logically sound. Mr. Bernanke has assured financial markets that policy will be guided by data, and data are sending mixed messages. Also, there is a present danger that Washington is headed for another fiscal showdown in October, which could result in a government shutdown. That would take a toll on the economy, and is reason enough for some for the Fed to keep its cushion fully stuffed.
Yet the prevailing view at the Fed seems to be that the time has come to get on with the delicate business of unwinding a program that never has been tried at this scale. Research suggests QE begins to lose its power to influence the real economy over time, while the odds of stoking asset-price bubbles or inflation only increase. So as long as the economy is moving forward, the Fed has every incentive to get policy back to a more normal setting.
And there are enough positive indicators in the U.S. to believe the country's economy is in little danger of stalling. A government report last week showed retail sales declined in July, but a separate update from the Treasury Department revealed that the budget deficit is 35-per-cent smaller than a year ago, a dramatic improvement that should be good for confidence: Americans are applying for jobless benefits at the slowest rate since before the recession, and the National Federation of Independent Business's index of hiring intentions jumped 16 per cent in August.
That's probably enough to convince Fed officials that they can begin tapering their asset purchases, especially since they will do so extremely slowly and carefully. Mr. Porcelli reckons the Fed will shave $15-billion from its QE schedule at each meeting of the policy committee until it stops in April next year.
Mr. Bernanke will be under pressure to communicate the Fed's intentions clearly. Interest rates spiked this spring when the chairman and other officials started talking about slowing their asset purchases. Currency markets also have been volatile, with the exchange rates of some emerging markets sinking to record lows. At the meeting of the Group of 20 leaders in St. Petersburg, Russia, this month, some leaders grumbled that the Fed's incautious talk of ending QE was responsible for their pain.
John Curran, a senior vice-president at CanadianForex in Toronto who has worked in financial markets for more than two decades, says the volatility has more to do with "twenty- and thirtysomethings punching buttons" than any real confusion over the Fed's path. According to Mr. Curran, "smarter money" has been positioning for the end of QE since the end of last year.
"We're getting back to real economies," that are driven by tangible factors such as profits and jobless rates, rather than almost exclusively by monetary policy, Mr. Curran said.