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The markets and the end of QE: prepare for a roller-coaster ride - Erica Alini

The Fed navigates the economic hazards.

This morning’s plunge across global financial markets makes one thing clear: The road that leads to the end of the Federal Reserve’s $85-billion-a-month bond-buying program is a treacherous one.

Japanese stocks dived 7.3% on Thursday, dragging down Europe and briefly spilling into North America before positive releases on U.S. jobless claims and new-home sales improved investors’ mood. The consensus seems to be that markets were reacting to a combo of bad news: weak manufacturing data from China and a Congressional testimony by Fed Chairman Ben Bernanke, as well as minutes from the Fed’s recent policy meeting, suggesting that the bank might be close to scaling back its massive monthly asset purchases, also know as quantitative easing (QE).

Frankly, neither the Congressional hearing nor the minutes contained new clues as to the timing, pace and modality of the Fed’s exit strategy. Investors, though, are known for occasionally getting cold feet not when bad news breaks but when it’s broadcast at louder volume, and U.S. stocks were already tumbling on Wednesday, before the survey on Chinese factory activity came out.

The risk of financial market volatility tied to the end of QE is well-known. “It’s hard to predict how the market will respond when the biggest holder of fixed income securities in the history of the world decides it has to sell them,” Senator Pat Toomey, a Pennsylvania Republican, noted during Bernanke’s testimony yesterday. New York Fed President William Dudley expressed similar concerns last week.

But if the market’s knee-jerk reaction to talk of QE was a dive this time, it could well be a wild up swing the next. The Fed’s plan for winding down QE, in fact, isn’t to scale back its monthly purchases gradually and steadily. Instead, it has made clear in recent weeks that it might hold or even reverse the tapering temporarily. The path to zero will be more like a roller-coaster than a downward slope—and markets are likely to mirror and amplify the ups and downs.

The Fed wants to have latitude to tweak its exit strategy if the economy doesn’t react as expected or unpredictable trouble strikes from abroad. On the one hand, it is concerned about tapering off too soon or too quickly. As Dudley, who isn’t one of the Fed’s doves, said recently, the bank has been “consistently too optimistic about growth over the 2009-2012 period” and believes it has withdrawn stimulus too early. It does not want to repeat that mistake. On the other hand, the Fed is also keenly aware of the dangers of prolonging the bond-buying, especially in terms of asset bubbles. Bernanke’s mentions of “reach for yield” risks have become more and more frequent. The Fed is trying navigate between Scylla and Charybdis and it seems to believe it will need to adjust the route as it goes.

The strategy is also likely aimed at avoiding a bearish turn in the markets serious enough to pose a threat to the recovery. If the prospect of a stop-and-go tapering off of QE was enough to send stock exchanges into a tailspin this morning, what would have happened if the Fed had adopted a more mechanistic approach, where the first wind-down move would have meant that the bond-buying bonanza was over once and for all?

The Fed could have set a specific date for the end of QE from the start, as it has done in the past for other policy measures, but that would have likely curtailed the impact of the new stimulus.

Needless to say, the current strategy is far from safe. Even if investors understand the Fed’s message, the ups and downs are almost certain to spur a certain amount of speculative bets. Still, it’s hard to see a better alternative.

As Bernanke, told Sen. Toomey yesterday: “There is no risk-free approach to this situation.”

Erica Alini is a California-based reporter and a regular contributor to CanadianBusiness.com, where she covers the U.S. economy. Follow her on Twitter: @ealini.