As the economic recovery in the developed world finally seems to be gathering sustainable momentum, one must not forget that it is the efforts and actions of economic policymakers, especially central bankers, which have led us out of the worst economic downturn since the Great Depression.
Leading the charge, and at times even being ahead of the curve, was Ben Bernanke, the outgoing chairman of the US Federal Reserve. A scholar of The Great Depression, Bernanke understood the severity of the financial crisis of 2007-08 and that it could not be fought with conventional economic ammunition. The government had to step in and restore credit and confidence in the financial system.
Without this interference, short term credit channels would have frozen and the spillover effects to the real economy would have been catastrophic. Thus, decisions such as the introduction of the Troubled Asset Relief Program (TARP) which involved buying distressed equity and assets of AIG, General Motors, Citigroup and other corporate giants were absolutely necessary.
The quantitative easing programs of the Federal Reserve, Bank of England, European Central Bank and the Bank of Japan were initially an attempt to restore confidence in the financial markets and provide short term liquidity. However, due to the severity of the economic downturn, these initiatives soon became tools for simulating the real economy.
As the financial systems of Japan and Europe were skewed toward being more bank-centric, the Bank of Japan and the European Central Bank focused on directly lending to banks. The Federal Reserve and the Bank of England on the other hand expanded their balance sheets (monetary base) by purchasing long-term bonds.
The fact that it is real interest rates that affect spending decisions meant that monetary policy actions by a Central Bank could simulate the economy even if nominal interest rates hit a floor of zero. This was the underlying reason behind deploying quantitative easing by the Ben Bernanke led Federal Reserve.
The Federal Reserve had run out of all its conventional monetary policy ‘ammunition’ as Dec 16, 2008, when the Federal Open Market Committee (FOMC) reduced the federal funds rate to near zero. Specifically, they cut this rate to trade between zero and 25 basis points.
Such a situation in which nominal interest rates hit zero and further money supply becomes irrelevant as money and bonds become perfect substitutes is called a liquidity trap. This was not the first time the US was facing a liquidity trap after a severe economic slump.
The interest rates were near zero during most of the late 1930’s after the Great Depression and in 1940, the average yield on the US treasury bills was 0.014 percent. The motivation of quantitative easing measures this time around was to push real interest rates into negative territory.
In 2008, the status of the US dollar as the world’s reserve currency and a safe haven asset was being questioned. The ‘perma bears’ which included the likes of American economist Nouriel Roubini, who had anticipated the 2008 recession, had set price targets for the broad-based S&P 500 index at 666.
It was said that the de-leveraging cycle after the US housing bubble burst would lead to deflation in the country. Then there was the ‘decoupling’ theory — that the emerging market heavyweights such as India and China would be the new engines of economic growth.
None of these predictions have been even remotely close to the truth. The US has come out of the crisis stronger than any of its developed market peers as well as the BRICS.
Paul Volcker is credited with ending the hyper-inflationary environment in the US of the late 1970’s. Alan Greenspan oversaw and helped guide the country through the crash of 1987, the savings and loans crisis of the early 1990’s, the Long Term Capital Management default, the Asian financial crisis and the dot-com bubble burst. All these events can put under the ‘crisis’ category, but Ben Bernanke oversaw a systemic global crisis where the financial system was at the edge of a cliff.
Extraordinary times call for extraordinary measures. Quantitative Easing as an unconventional monetary policy response has worked according to any yardstick.
Unemployment had gradually and consistently dipped lower and inflation has not skyrocketed. Ben Bernanke has done his bit. Now Janet Yellen, who assumes office Feb 1, has to slowly withdraw the liquidity injected in to the markets during the Bernanke era as the economy heals.
The markets can handle rising US real interest rates provided they rise in a gradual manner. A 1994 scenario wherein the US bond market witnessed a crash due to rapidly rising interest rates must be avoided.
Janet Yellen’s dovish stance has market participants mildly bullish at the moment with the US stock market gradually inching higher to record highs.
All Yellen has to do to cement Ben Bernanke’s legacy as a successful Fed chairman is not to pull the plug on QE taper too much, too fast.
(Vatsal Srivastava is a senior market analyst. The views expressed are personal. He can be contacted at [email protected])