The Helicopter Pilot Does An Auto-Rotation...

Friday finally saw a long overdue correction in forex markets. EUR-USD ended the day at 1.3977 (i.e. 1 EUR = 1.3977 USD), almost two big figures down from the intraday high of 1.4157 (which means the EUR weakened and the USD strengthened)

All day long, the market was waiting, wishfully it seemed, for some big bang announcements from Federal Reserve Governor Ben Bernanke in his speech at the Boston Fed Conference. The market, over the past few weeks, has been in a firm sell-USD mode, on the expectations of massive balance sheet expansion (will explain later) by the Federal Reserve.

The market had been doing this because the US economic growth has weakened over the past few months and the Federal Reserve has communicated that it is concerned about the situation and intends to take steps to resolve it. In particular, the US unemployment rate is almost at 10%, which the Fed thinks is much higher than a long-run stable unemployment rate of 5% to 6%, and inflation is around 1%, which is much lower than a long-run stable inflation rate of 2%. Given this backdrop, the Fed is expected to ease monetary policy i.e. take measures which promote the supply of money, growth of credit and help in reducing market interest rates, so that people can undertake economic activity and growth gets a boost.

The most direct way for a Central Bank to ease monetary policy is to reduced the base interest rates that are set by them. However, the benchmark nominal interest rate in the US, called the Federal Funds target rate, is at 0% since December 2008. They cannot reduce it further (this is called the zero bound constraint). What, then, can the Fed do to further reduce market interest rates and promote economic activity? Well that was what Bernanke was speaking about : Monetary Policy Objectives and Tools in a Low-Inflation Environment (http://www.federalreserve.gov/newsevents/speech/bernanke20101015a.htm)

Let it be noted however, that this is by no means the first such speech. Several papers have been written on monetary policy alternatives at zero interest rates, and Bernanke himself is considered to be an authority in this area, having studied the US Great Depression and the Japanese Lost Decade in great detail. He's a firm believer in the use of monetary policy in fighting recessions (periods of declining economic growth) and deflation (negative inflation). One of his most famous comments made in 2002 was that he would drop dollar notes from a helicopter in order to keep the economy going.

Given all this, markets may not have been unjustified in expecting more monetary easing by the Fed. In particular, they expect a resumption of quantitative easing - the tool employed by the Fed where in they buy US treasuries (i.e. bonds issued by the US Government) and other bonds. In case of bonds, prices and market interest rates (yields) are inversely related. When the Fed buys such bonds, the price of the bonds goes up. Correspondingly, the yields go down and the objective of monetary easing is satisfied. The question is, where doe the Fed get the money to buy these bonds? The answer is - nowhere. It prints the money. The Fed controls the supply of money (i.e. US dollars) in the world. It can decide to print as much money as it wants. Of course, doing so will lead to a decline in the value of the US dollar. That will happen because any currency is supposed to act as a store of value. If there is more of that currency in circulation, then the value of other goods in that currency will increase. This is why people have been selling the US dollar - anticipating that the Fed will do further QE, by printing dollars, which should cause the dollar to weaken. (I may mention that the Fed has already undertaken QE of about 1.7 trillion US dollars last year, which is a huge amount. The size of the Fed's balance sheet has shot up from about 0.8 trillion USD to 2.5 trillion USD as a result)

However, post the speech made by Bernanke, markets were disappointed. If one goes through the speech, there is one line which is of particular importance: "In a world in which the policy interest rate is close to zero, the Committee must consider the costs and risks associated with the use of nonconventional tools when it assesses whether additional policy accommodation is likely to be beneficial on net."

Which is to say that the Fed is not thinking of QE as a one way street. They are equally worried about the negative fallouts of QE. Bernanke goes on to mention some risks of QE: "One disadvantage of asset purchases relative to conventional monetary policy is that we have much less experience in judging the economic effects of this policy instrument, which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public. Another concern associated with additional securities purchases is that substantial further expansion of the balance sheet could reduce public confidence in the Fed's ability to execute a smooth exit from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might lead to an undesired increase in inflation expectations, to a level above the Committee's inflation objective"

The second point is particularly worth noting. Essentially, the Fed, by doing QE and purchasing assets (in this case, bonds) prints dollars. The risk here is that they may end up printing so many dollars that the dollar ends up becoming worthless over a period of time. It may not represent a store of value any more. This is also a form of inflation, which results from money creation. It may seem a little difficult to grasp intuitively since its much less common than the normal form of inflation which we are used to - goods price inflation. Inflation usually happens when there is a lot of demand for goods, which cause the prices of those goods to rise over a period of time. However, it can also happen when the country's currency starts losing value, because of which the denominated prices of goods in that currency begin to rise. The Fed is worried about the possibility of such inflation resulting because of the steps that they have taken.

Once Bernanke made his speech, markets realised that they could not assume that QE was certain. Consequently, they could not be completely sure that the US dollar would weaken and hence people started squaring (i.e. closing) their positions in US dollars (since they had sold US dollars earlier, they were buying them now). Accordingly, markets corrected and the US dollar strengthened against most currencies.

Looks like the helicopter pilot is now trying to do an auto-rotation.