The Moment of Truth for the US Federal Reserve

The US Federal Reserve’s balance sheet is now over US$4 trillion dollars. Congratulations!

According to the latest official numbers, it closed Wednesday 11 December at US$3.994 trillion, and would’ve probably surpassed US$4 trillion within minutes of the market opening the very next day. That’s because, despite the supposed economic recovery in the US, the Federal Reserve continues to monetise US$85 billion in Treasuries and mortgage backed securities every month.

Back in the good old days, when men were men and interest rates were not at the ‘zero-bound’, the Fed’s balance sheet was just US$878 billion. That was in January 2007. So in the space of seven years, the Fed has added over US$3 trillion dollars to its balance sheet.

US$3 trillion dollars…

It seems like a lot…and it is a lot. But the expansion hasn’t led to rampant inflation like many people predicted.


The Fed’s actions have merely prevented the full effects of a deflationary cycle from taking hold. They paid top dollar for billions worth of poor quality mortgage backed securities, taking them off bank balance sheets, avoiding the need for capital destructive writedowns. 

Through their purchases of Treasury securities, the Federal Reserve helped keep interest rates low while the US government spent trillions to keep the economy afloat. Now, the US government’s debt-to-GDP ratio is over 100%, up from around 50% before the credit crisis. 

We’re now five years into the ‘recovery’. It’s taken a lot of firepower to get the economy to this stage. Now, the moment of truth is here. The US Fed wants to start to ‘taper’ its asset purchase program. But ‘asset markets’ – the chief beneficiary of the Fed’s program – don’t like the sound of it.

But ‘asset markets’ – the chief beneficiary of the Fed’s program – don’t like the sound of it.

If the Fed does try to wind back its unprecedented intervention, the emerging markets will feel the pinch first. That’s because the flow of capital usually goes from the core to the periphery. The Fed is at the core of global finance these days. The electronic ‘money’ that it emits goes through the global banking system and out into the periphery (emerging markets).

When it hints at winding back the emission of dollars, markets on the periphery will suffer first as the flow reverses and moves back to the core.

The Fed began hinting at the beginning of the end for quantitative easing earlier this year. While it hasn’t damaged the US or the major developed equity markets yet, it has hit many emerging markets hard. Their currencies and asset markets have all taken a hit.

Being so dependent on Asia, Australia is considered somewhat of an emerging market too. Our currency, equity and bond markets have all taken a hit over the past month or so. But you can’t put it all down to the ‘taper’.

And you can’t blame China either. It’s still powering along, sucking in vast amounts of our iron ore and other raw materials. According to last month’s trade figures, China took in around 40% of our exports. That’s quite a dependency we’re developing.

So it is a good thing (until it is not) that China’s credit boom refuses to slow down.  In November, total social financing (the broadest measure of credit growth) was 1.23 trillion yuan, or about US$200 billion. That’s US$2.4 trillion annualised. Massive.

That’s a big jump on the US$140.6 billion monthly expansion in October, and just goes to show that China’s leaders have no stomach for curtailing the Middle Kingdom’s out of control credit beast.

Maybe China’s leaders won’t have to do anything. Maybe the ‘taper’ will do it for them. Because if the US Fed stops emitting so much money, there won’t be so much of it making its way to China. Remember, China loosely pegs the yuan to the US dollar. This means it effectively imports US monetary policy.

If ‘tapering’ represents a tightening of policy (and Ben Bernanke reckons it doesn’t) then it may just restrain China’s monumental credit growth.

That wouldn’t be good for Australia, given that we look to be entering a prolonged period of sub-par economic growth. Dan Denning has made the case that 2014 will be the year of the recession. We agree. In fact, Australia is pretty much in recession now…it just depends on how you measure it.

On a standard GDP measure, we’re growing slowly but not going backwards. That’s because standard GDP measures economic output…or production volumes. It doesn’t take into effect the prices received for that output.

As an example, net exports were a major contributor to the standard measure of economic growth last quarter. That’s because our export volumes increased. But in real terms, Australia ran a trade deficit during the quarter because (despite the increase in volumes) imports prices increased more than export prices…hence the deficit.

So when you factor this in the economy is barely growing. If, or more likely when, China’s credit bubble hits a pin of some kind next year, Australia will be in a recession. And the mining investment boom will begin to wind down ever quicker from 2014, leaving an employment and investment hole for the economy to deal with.

The Australian Workforce and Productivity Agency just came out with some pretty sobering estimates on employment in the resource construction sector:

A highly volatile phase lies ahead for Resources Project Construction, which is expected to see employment plateau at first and then decline rapidly in coming years. Under the low growth scenario (considered the most likely due to the lower probability of projects proceeding to the committed stage), employment is expected to drop slightly from 85,819 workers in 2013 to 83,321 workers in 2014 and then decrease quickly to 7,708 by 2018.

That’s some fall. The Agency expects more than half of the jobs lost in this decline to be replaced with jobs growth in mining and oil and gas operations. But if China slows more than forecast, the jobs growth expectations will prove overly optimistic.

Whichever way you cut it, Australia faces a tough future. High wages, a high dollar and uncompetitive industries are the structural impediments we face. There will be no decent recovery unless we tackle structural reform. But such reforms are too politically tough to carry out. A country needs leaders to get the job done. Australia just has followers…on both sides of politics.

The only problem is, we don’t know who’s following who.


Greg Canavan+
for The Markets and Money Australia

Greg Canavan

Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing.

He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’.

Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors.

Greg Canavan

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4 Comments on "The Moment of Truth for the US Federal Reserve"

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Justin King

Take a look at John Mauldin’s new book : Code Red.

Justin King

Lack of M2, velocity of money, is the main problem with the system these days.

Kerry Davie

Greg, it’s “who’s following whom” ( the ‘m’ is important, whether it’s M1 M2 M3 or whatever)


When ‘Master’ dies, so does the Pekingnese lapdog that licked Master’s boots as he sat his yellow ass on the Jade Throne.

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