Here's How the Party Will End If the Fed Pulls Back

Richard Fisher, former president and CEO of the Federal Reserve Bank of Dallas.
Adam Jeffery | CNBC
Richard Fisher, former president and CEO of the Federal Reserve Bank of Dallas.

Despite market volatility and a debt timeout, liquidity-driven growth will end when the Fed reverses its monetary policy—and that end is now in the horizon.

Recently, Dallas Federal Reserve President Richard Fisher noted that when to dial back is the key because stopping would be "too violent for the marketplace."

In turn, the Fed Chairman Ben Bernanke warned that holding interest rates too low for too long has its risks and suggested that the Fed could slow bond purchases. Afterwards, the markets responded as one might expect.

But this is just the prelude. When the Fed shall move from words to actions, the repercussions will be felt worldwide and this is how it's going to happen.

Liquidity-driven growth

Until the recent market turmoil, stocks rallied for the fourth week, with Dow Jones (15,354) and S&P 500 (1,667) hitting new highs. Meanwhile, gold prices plunged on the strength of the U.S. dollar to 1,360, whereas Brent oil was around $96. To investors, the liquidity from the major central banks in the U.S., Europe, UK and Japan was manna from heaven.

Then came May 23, when Nikkei dropped some 7.3 percent, due to concerns over yen, yields, and China's economy. In the past four months, foreign investors have pumped over $60 billion to the Japanese market. With the overheated economy, a chunk of "fast money" exited.

With the onset of the global crisis, the Federal Reserve initially reduced short-term interest rates to near zero. Since that proved insufficient for recovery, Fed resorted to quantitative easing, by starting the purchases of long-term bonds.

The Fed's bond holdings alone have almost tripled since March 2008. And since last fall, the Fed has purchased mortgaged-backed securities and bonds by $85 billion each month. As a result, Fed's holdings in securities will amount to $4 trillion by the year-end of 2013. At the same time, the balance sheets of the big four central banks (the Fed, European Central Bank, Bank of Japan, and People's Bank of China) have more than quadrupled from $3 trillion to more than $13 trillion during the past half a decade.

As rounds of QE have pushed nominal interest rates below the rate of inflation in the United States, it was hoped that negative "real" interest rates would encourage lending and borrowing, and thus to stimulate economic activity. But this is growth by addiction, not growth by fundamentals.

While economic growth has picked up, it remains anemic at 2.2 percent real GDP growth on average since the end of the recession in mid-2009.

As long as the U.S. is growing well below potential (about 2.2 percent since the Great Recession), inflation risks remain low and disinflation is the new normal, which serves as a still another reason to keep interest rates low.

Keeping the course – but only for another few months

What happens when the Fed will start reducing its balance sheet?

The mandate of the Fed is to promote price stability and full employment, which is still far above the target range of 5.2 to 6 percent. Bernanke has also indicated that the Fed will not revise the monetary policy until unemployment will decline below 6.5 percent. Furthermore, inflation remains below the Fed target of 2 to 2.5 percent.

As a result, Bernanke is likely to continue bond buying for another few months, especially as current fiscal tightening—in particular, "the expiration of the payroll tax cut, the enactment of tax increases, the effects of the budget caps on discretionary spending, the onset of the sequestration and the declines in defense spending," as he put it recently in the Congress—works against monetary policy.

The problem is that as the Fed's internal divisions will increase, the effectiveness of continued quantitative easing is decreasing, even as exit has become more challenging.

How the party will end

When the process of unwinding will eventually begin, it is likely to occur in three ways outlined by Bernanke and New York Fed chief William Dudley. However, each comes with potential pitfalls.

The Fed could stop reinvesting the proceeds of maturing securities. This approach, however, requires a long time to reduce the huge balance sheet.

The Fed could also raise short-term interest rates. This way it could reduce potential inflation pressures, but the approach is not appropriate as long as growth lingers and disinflation rather than inflation is the primary challenge.

Finally, the Fed could gradually sell mortgage-backed and Treasury securities. However, when Bernanke recently suggested the possibility of such an option, it was enough to cause volatility in the markets.

The simple reality is that moving too fast or too slow could severely disrupt the lingering recovery and drive the U.S. economy into recession.

Meanwhile, even as the markets keep breaking all-time records, the U.S. debt continues to soar because there is no debt adjustment plan.

Challenging fall

While the Fed is considering its options, U.S. government debt has soared to more than $16.8 trillion, which exceeds the value of U.S. GDP by some $1.1 trillion. That translates to $148,000 debt per taxpayer and over $53,200 debt per person in America.

The United States hit the current debt limit of $16.4 trillion on December 31, 2012. Next day, Washington agreed on a "mini-deal," which deferred difficult decisions. Meanwhile, the Treasury Department resorted to "extraordinary measures," to avoid default. Usually, this can provide a 6-8 week timeout. However, Congress deferred the deadline by a law that suspended the debt ceiling until May 18.

Initially, markets expected the Treasury Department to return to its accounting wizardry, which could have given Congress another 6-8 weeks until early August. In reality, the timeout will prove a bit longer, thanks to the Treasury's increased tax revenue in April, the initial impact of the automatic spending cuts, and the impending payback by the mortgage financing giants Fannie Mae and Freddie Mac.

Consequently, a new debt ceiling will not be needed until the Labor Day, possibly even October 1. The bad news is that no plan exists to resolve the fiscal stalemate in Washington. Nor is it likely that a viable plan will evolve before the deadline.

As a result, the U.S. debt debate is likely to intensify amidst rising market volatility, the highly anticipated German elections and Italy's political crisis in Europe, and increasing uncertainty in Japan. When the Fed will finally revise the course, other central banks will follow in the footprints. That's when the liquidity masquerade will end.

The most difficult days of the post-crisis period are not behind, but still ahead.

More Steinbbock:
Steinbock: Euro Zone Adrift: Failed Austerity, Wrong Course
Steinbock: Is Finland Pricing Itself Out of Global Competition

Dr. Dan Steinbock is Research Director of International Business at India China and America Institute (USA) and visiting fellow at Shanghai Institutes for International Studies (China) and the EU Center (Singapore).