Tuesday, January 4, 2011

When does the Fed take away the punch bowl?

It is said that the role of a central banker is to take away the punch bowl just as the party is getting going. Now that we have a tepid recovery in the US and there are signs of stabilization in Europe, what happens after the expiry of QE2?

John Taylor (who is best known for the Taylor Rule) recently wrote on December 18, 2010:

David Einhorn of Greenlight Capital was quoted in The Telegraph as it may be time for the Fed to start thinking about how to tap on the brakes:
"The crisis that required zero interest rates has passed," said Mr Einhorn, who co-founded and runs Greenlight Capital, a $6.5bn (£4.2bn) fund. By not raising rates "it increases the chance that governments will over-borrow and fall into a debt trap".

The criticism of the Federal Reserve comes as it embarks on another $600bn (£380bn) of quantitative easing – or printing money – in an effort to fire up a stronger recovery next year.
Affirm the Bernanke/Greenspan put, or take away the punch bowl?
The possibility that the Fed may tighten is a 2H 2011 story. When that time comes, what does Helicopter Ben do? Does he err on the side of avoiding deflation with QE3 or does he take away the punch bowl?
Stocks already appear to be overvalued. The Shiller P/E ratio is 22, which is not exactly cheap, and the Tobin Q shows US equities to be 74% overvalued.

How will the markets react if the Fed takes away the punch bowl? Or does it? For now, I wouldn't worry too much and enjoy the liquidity party that the Fed is throwing. Leave the worrying for the 2H.

According to the federal funds futures market, the Fed will begin raising rates sometime next year—with the federal funds rate reaching about ½ percent by December 2011. In fact, rising rates next year has been the implicit forecast of the futures market for the past year—except for the month of October during which many FOMC members were promoting quantitative easing.

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