Today might be the day when the U.S. Federal Reserve starts scaling back its massive, open-ended asset buying program, also known as QE3
Back in May the Federal Open Market Committee (FOMC), the Fed’s rate-setting body, declared the U.S. economy was starting to shape up enough to withstand a stimulus reduction sooner rather than later. In June the Fed gave a timeline: Barring unpredictables, they would begin to shrink the size of their monthly asset purchases later this year and end them around mid-2014.
Now, “later this year” means either today, at the end of FOMC’s September meeting, or at the end of the analogous Fed confab that’s going to take place in December. (The committee will meet in October as well, but there won’t be a press conference after that session, and the Fed has been using those pressers to explain to the public what its formulaic FOMC statements mean exactly. Thus, it is highly unlikely anything of relevance would happen then.)
Does the timing make a difference to Canada whether the taper starts today or three months from now? And, in general, how will it play out north of the border? To answer both questions, I turned to Douglas Porter, chief economist at BMO Capital Markets, and Michael Dolega, economist at TD. Here’s a condensed version of what they told me:
If you’re not buying and selling on the stock market this afternoon, today or December doesn’t make a difference. A decision not to taper today would signal to the markets that the Fed doesn’t think the economy is strong enough yet to take it, said Porter. It would be the opposite of a vote of confidence in the recovery. In that case, expect doldrums in equities markets, a rally in Treasurys and the U.S. dollar to weaken notably.
On the other hand, yields on long-term bonds have been rising since May, so the markets have already largely priced in the possibility of a September taper and won’t reverse that adjustment should the taper start in December, said Dolega. The point of QE was to keep long-term borrowing costs low in order to allow firms and families to borrow cheaply and help the economy expand. When investors started foreseeing an end to the bond-buying program, they adapted their portfolios and expectations, pushing up yields. This means: a) that the stimulus effect of QE3 has waned and the Fed wouldn’t get much bang of its buck in keeping asset purchases at current levels until December; b) that the biggest jump in long-term interest rates we’re going to see has already happened.
The taper is good for Canada. This is a widely held view, and one that the Bank of Canada has voiced as well. The gradual end of QE will likely help Canada switch from growth fueled by household consumption and the housing market to one driven by exports and, hopefully, business investment. Higher long-term interest rates make it more expensive to borrow for anything from ski vacations—for which you should never ever take on debt, anyway—to mortgages. Exports, goes the theory, will fill that gap because: a) The U.S. economy will be growing (otherwise, the Fed wouldn’t be tapering); b) the downsizing of QE will push up the value of the U.S. dollar compared to the loonie, making made-in-Canada products and services cheaper for Americans than they’ve been for many years.
You might wonder why, since long-term bond yields and mortgage rates have supposedly largely adjusted to a September taper, the Canadian housing market has given no sign of cooling yet. Both Porter and Dolega believe climbing borrowing costs have given residential real estate a last, small boost by pushing some undecided buyers to jump off the fence before rates climb even higher. In the end, though, higher rates will cool the demand for houses.
A few things could go wrong—including majorly wrong—but they probably won’t. The idea that Canada will benefit from the taper rests on the assumption that the U.S. economy is growing stronger—hence the taper. But what if the Fed starts tapering and somehow the U.S. economy slows or tips back into recession?
The main threat to the U.S. recovery from within the U.S. itself is — you guessed it – Congress. An October federal government shut-down, another debt-ceiling fight or prolonged public-sector spending restraint are all risk factors, though it is highly unlikely they will plunge the country into another recession, said Dolega. Another serious eurozone crisis flareup or a financial crisis in China, are much more threatening.
The good news here is that there’s something the Fed can do if things get really bad. The not-so-good news is that there isn’t much the Fed can do if things only get sort-of-bad. The FOMC has repeatedly noted that adjustments in the amount of assets it buys can go both ways: Up or down, depending on how the economy is doing. This makes it sound like QE is a nimble tool—like a toy plane you can swiftly send up or down by pushing buttons on a remote control. In fact, it isn’t. The impact of QE on the economy depends on how markets react to it. In order for a new increase in asset purchases to translate into lower long-term rates, the Fed would have to convince investors that it isn’t going to reduce its bond-buying again for the foreseeable future. “The prospect of tapering would have to be out of people’s minds,” said Dolega. It’s not impossible to do, but it’s probably a last resort measure for a worst case scenario. If the road gets a little bumpy, we’ll just have to hold on tight.
There are at least two other ways in which things could get sour for Canada. One is if higher interest rates trigger a harsh landing in the housing sector. Dolega, however, noted that in the larger market for detached homes, supply levels don’t seem to be a problem. Oversupply risks are more serious for condo builders and owners. Still, rental demand for apartments should provide a bit of a cushion.
The other snag is that the taper might put downward pressure on commodity prices. Porter, however, noted, the onset of QE3 doesn’t seem to have had much of an impact, so you’d expect the same to hold true while the Fed is scaling it back.
Erica Alini is a reporter based in Cambridge, Mass., and a regular contributor to CanadianBusiness.com, where she covers the U.S. economy.