Ben Bernanke’s term as the Chairman of the Federal Reserve ended on Jan 31, 2014. He presided over the last meeting of the Fed and signed off on the decision to pare back purchases of Treasury bonds and mortgage backed securities to $65 billion a month from $75 billion a month with clear indications that more reductions in bond purchases are on the way. These bond purchases were part of an unusual monetary policy maneuver called quantitative easing round three (QE III). Announced in September 2012, QE III involved $40 billion a month mortgage bond purchases in the open market with an aim to keep long-term interest rates low which in turn would increase borrowing, investment, and spending. In December 2012, a decision was made to increase the bond purchases to $85 billion a month. In June 2013, Bernanke announced that the Federal Reserve will consider a reduction in bond purchases contingent on positive economic data, inflation target of 2%, and unemployment target of 6.5%.
The Fed’s decision hinges on an improving US economy. The US economy is forecast to grow at well over 3% during the second half of 2013 and the Fed forecasts that this growth rate will be sustained in 2014 and well into 2015. The Fed could deviate from its plans if outlook for growth, inflation or unemployment shifts drastically. However, the unanimity in the Fed’s decision suggests that Fed economists are confident about sustained US economic growth.
All the prior announcements to reduce the stimulus or even mere suggestions to reduce the stimulus were followed by stock market declines around the world. The latest decision by Federal Reserve last week sent ripples through the global economy. The Dow Jones dropped 1.2% on Wednesday, Treasury prices rose, and the currencies of a host of emerging nations declined. The June 2013 announcement by the Fed had also sent the currencies of emerging countries into a tailspin. The monetary easing unleashed by the Fed and other leading central banks in developed nations found its way to emerging nations setting of a series of higher asset prices and higher capital account inflows. As the tide on monetary stimulus turns emerging nations that enjoyed higher capital inflows have to grapple with capital flight, declining currencies, higher inflation, and prospects of economic slowdown. These emerging nations are walking a thin line between raising interest rates to slow down inflation and capital flight and maintaining their interest rates to sustain and increase economic growth. The policy actions by developed and emerging nations definitely promise a lot of real life lessons in macroeconomic policy for business students. Let us wait, watch, and learn.
Source: The above note was summarized from the following articles published in the Wall Street Journal.
1. “Fed Sticks to Script on Paring Bond Buys”, Jan 29, 2014.
2. “Next Cut in Fed Bond Buys Looms”, Jan 20, 2014.
3. “Investors Look Toward Safer Options as Ground Shifts”, Jan 29, 2014
Dr. Subramanian “Subbu” Rama Iyer is an assistant professor of Finance at UNM Anderson School of Management. Dr. Iyer holds an undergraduate degree in Chemistry from Mahatma Gandhi University, and a MBA and PhD from Oklahoma State University. He has worked in the banking industry in India. During the 2012–2013 academic year he was a visiting assistant professor of Finance at UNM Anderson. He joined the faculty as a full-time assistant professor of Finance starting this 2013– 2014 academic year.
Dr. Iyer’s research topics are payout policy, corporate diversification, credit spreads, and investor sentiment. He is a college football fan, likes to fly kites, and also likes music.