Why Stimulus will Continue

According to Richard Fisher—president of the Federal Reserve Bank of Dallas—and Narayana Kocherlakota—president of the Federal Reserve Bank of Minneapolis—it is important for the Bernanke-led U.S. Federal Reserve to remain “accommodative” in its policies and to think carefully through the consequences of drawing down on the ongoing stimulus program.

If you recall, the markets shuddered just last week in response to the Fed’s musings over a possible termination of its asset-buying program, which many believe has been responsible for keeping the markets moving upward.

Up next year is the Federal Open Market Committee vote, which will decide when and how to end the Fed’s stimulus program. Both presidents mentioned above will be voting in that motion.

At present, the U.S. Fed counts $3.47 trillion on its balance. That’s an all-time record. Nonetheless, after June 18, when Bernanke disclosed the Fed may begin cutting down on its $85 billion/month bond purchasing program with a view toward ending the program completely sometime around the middle of 2014, the Standard and Poor’s 500 Index has shed 4.8 percent, per Bloomberg.

According to Kocherlakota, the Fed’s stimulus program ought to be pegged even more closely to national unemployment figures (which presently are around 7.6 percent for May data).

Bloomberg quotes:

“The committee should continue to buy assets at least until the unemployment rate has fallen below 7 percent,” he [Kocherlakota] said. The purchases should continue “as long as the medium-term outlook for the inflation rate remains below 2.5 percent and longer-term inflation expectations remain well anchored,” he said.

All of this appears despite Bernanke clearly indicating the Fed does not have any specific timeline drawn up and that all actions with regard to tapering the stimulus would be considered carefully and in sync with market responses.

However, taking the general statements made by both presidents, the consensus appears to be that the recent market reactions to the Fed’s declaration does not present immediate cause for concern. In short, both stressed the fact that Bernanke intends the Fed’s future actions to be heavily skewed toward flexibility and accommodation rather than following any over-determined course of action.

Aside from the S&P decline I mentioned earlier, 10-year U.S. Treasury bond yields shot up to a near-two-year high, and China’s ongoing crises in the manufacturing and financial sectors haven’t helped at all. Indeed, the People’s Bank of China just recently issued a warning to domestic banks to increase oversight of their lending practices, in a move designed to dissuade fears of an impending liquidity crisis.

All these factors together have significantly increased the risk of a massive flash sell-off, which would result in a severe detriment to the fledgling U.S. economic recovery. That recovery has really only just gotten underway, with housing and unemployment numbers on a steady rise.

Fisher, for his part, underscored the recent strengthening of the U.S. dollar, identifying an underlying confidence in the economy at large. And as he stressed, the Fed’s adherence to an accommodative course of action meant it will likely continue to be committed to quick adjustments and further quantitative easing the moment the market displays any overt signs of distress.

BRIC Takes Note

All that has not been lost on BRIC—the international bloc of emerging economic powers. A strong U.S. dollar would obviously have a big impact on exchange rates. Accordingly, Brazilian President Dilma Rousseff and Chinese Premier Xi Jinping have already begun talks, which will expand to include the leaders of Russia, India, and South Africa later this week, reports Reuters.

The expected sell-off the Fed’s withdrawal will likely cause could make the currencies of those nations to decline sharply. Brazil’s real is already at four-year lows, and stocks are likewise down. This could impact domestic inflation in those nations.

Less stimulus action means reduced capital inflows to BRIC nations, meaning their exports suffer. In short, BRIC expects more transparency from the U.S. Fed regarding its future course of actions.

During the financial crisis of 2008, several nations’ central banks decided to devise currency swap agreements in order to keep their own liquidity stable. This March, Brazil and China joined that group, creating an agreement under which they can trade up to $30 billion annually in their respective currencies and thus weather international financial fluctuations.

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