A new chapter begins in the history of the financial crisis. On Wednesday evening in the U.S., the central bank once again turned off its liquidity tap: a weighty decision, one which marks a certain degree of normality for the American economy more than six years after the collapse of the American investment bank Lehman Brothers.
To fight against the chaos that event brought about in the financial industry, the Federal Reserve did not hesitate to break the traditional rules of central bank monetary policy. It was not content to play around with the traditional instrument of central bankers, i.e. interest rates. Very quickly, its then-president Ben Bernanke, an academic specializing in the 1929 crisis, believed that bringing interest rates to zero in order to lower the cost of loans to businesses and households would not be sufficient to escape a serious depression. The Fed therefore set about a large-scale buyback of market assets, particularly American public debt.
Betting on the Wealth Effect
It was a leap into the unknown that experts call “quantitative easing.” The objective was to lower the return on public debt to lighten its financing cost, but above all to oblige investors to look toward other, more profitable assets (such as shares or real estate) in order to increase their price. After the subprime mortgage crisis, it was necessary at all costs to revive the American property market and fight against household debt brought about by the collapse in the value of their homes. It was thus necessary to boost the stock market in order to generate what economists call the “wealth effect.” When Wall Street is doing well, Americans — businesses as well as households — see their portfolios swell and are encouraged to spend.
Any extension of this “unconventional” monetary policy is to be stopped under the leadership of Janet Yellen, Ben Bernanke’s successor at the head of one of the most powerful institutions in the world. The start of this return to normality is not without risks. For several months, the Fed has been preparing the ground, terrified at the idea of brutally depriving investors of their ever more generous windfall. The credit squeeze began in June 2013. In the face of an improving American economy, the Fed gradually slowed the rate of increase of its buybacks: from 85 billion additional assets per month, it was reduced in successive stages until the program was brought to an end — not without triggering some turbulence in developing countries in the meantime, when the turnaround was announced in May 2013.
A Communication Battle
Thanks to effective communication, something which has become crucial for central banks, the Fed has nonetheless managed to avoid any major incidents on the markets. The risk of a bond market crash — in other words, a severe rise in interest rates on debt securities with the corresponding crash in their value, potentially very disastrous for their holders — seems to have been avoided. Bondholders have had time to prepare themselves. When the Fed closed its tap again, it also took good care not to pull out the plug. Its balance sheet will remain laden with bonds for many years to come until they reach maturity. And the central bank will make sure to maintain its market exposure until its interest rates go up again.
It is a complete normalization of monetary policy which has already been focusing investors’ attention for several months, for the age of almost zero-cost loans and incentives to become indebted really will have finished. The job of the analysts is trying to work out when this potential upheaval will really take place. However, if being able to predict when things will happen is crucial for the central bank, it still cannot tie its hands too much.
Doubts about the Actual Health of the American Economy
Everything will depend on the state of the American economy. Unlike the European Central Bank, the Fed has explicitly given itself the objective of lowering unemployment. Returning to below the 6.5 percent level should theoretically have triggered an increase in [interest] rates. Its fall to 5.9 percent of the active population in September has not, however, changed anything. Even though the Federal Reserve Board has observed a net improvement, it is still debating the real health of the American labor market. The number of unemployed persons discouraged by the crisis and who are no longer looking for work is disputed.
And so is the strength of the recovery. This year growth was, to say the least, uneven. After a very negative first quarter impacted by snowstorms, the second saw a spectacular leap of more than 4 percent (annual rate). Analysis of the figures for the third quarter should be examined very carefully, the whole question being whether growth can go above a mediocre 2 percent to pass the 3 percent level, a figure more in line with a classic program for getting out of an economic crisis. As in Europe, the return to 2 percent inflation will also be key.
The Question of Inequality
In spite of the undeniable strengths of the American economy, such as the cost of energy with shale gas or labor costs, uncertainties hang over its real soundness once the tap is closed again. So much so that Bill Clinton’s former economics adviser and unsuccessful candidate for the presidency of the Fed, Larry Summers, is raising the specter of a “secular stagnation” in advanced economies: a world without real growth, marked by weak demand linked to stagnating incomes of households too heavily in debt.
Hence, there is a debate on the economic impact of evermore significant inequalities in the U.S., so much so that the credit ratings agency Standard & Poor’s expressed its worry about it in a report in August. Continued increase in inequality would threaten consumption, with more affluent households tending to save a significant portion of their income. Despite comfortable margins and an abundance of cash, businesses cannot see any stable market and are hesitant to invest, preferring to distribute money amongst their shareholders. Paradoxically, this is a movement which is accentuated by the Fed’s extraordinary policy. By raising the price of assets and lowering the price of money, the Fed has inflated the assets of the most affluent and encouraged businesses to deposit their vast liquid assets rather than investing. Such are the many elements which undoubtedly explain why Capital, by the French economist Thomas Piketty, has been immensely successful in America.