WHAT TO EXPECT ONCE FED ENDS BOND-BUYING PROGRAM
The Federal Reserve ended its bond purchase program on October 29, 2014, which has pressed disagreement among policy makers, economists, and investors on its effect. The central bank said the program helped achieve its goal of reducing unemployment in the country. Ending the program marks the real test of the economic recuperation. But will the US economy continue to grow even without this program?
Shrinking money supply. The US economy is near recuperation partly because of massive amount of cheap money within the economy. Current gross domestic product (GDP) annualized growth rate is above 3% and unemployment rate is at 5.9% as of present, not to mention the positive inflation is almost 2%. Ending the program may help cut down the excess supply of money in the economy, which may cause inflation, as well as retain inflation close to Fed’s long-run 2% target.
Escalating interest rates. For the longest time, interest rates have been close to or at zero due to the US central bank’s different stimulus package such as the bond-buying program offered to banks. Several saving mechanisms including certificates of deposits (CDs) have been giving savers historically low CD rates, barely keeping up with inflation. Therefore, expect rising interest rates.
Declining bond prices. The bond value is inversely related to interest rates. Hence, bond prices will drop due to an eventual rise in interest rates. Investors with bond holdings should reconsider rebalancing their investment portfolios to deal with the risk of being negatively affected by increasing interest rates.
Repricing equities and other investment instruments. Investments valued through discounted cash flows in the future to the present based on interest rates or cost of funds will go through a downward adjustment in valuation once interest rates increase. This will question the true value of many recent valuations of giant IPOs such as Facebook and Alibaba, which were brought to the market in times the rates were near zero, and its value may decline when rates climb. Note to investors: Take into account the consequential risks on your portfolios upon ending or repealing the bond purchase program. If needed, rebalance your portfolios to address such perils.
Increasing savings rate. Recession erased many investors’ life savings, and shocked many market participants into cashing their investments and looking for a shelter to secure their money solely for safety of capital. That makes the financial crisis more severe by worsening the liquidity problem that had affected the financial system. One of the reasons the US central bank launched the said program was to lessen rates and make a disincentive to savings, and to encourage continued investment into the stock market and other types of investments with possibly better yields than savings accounts. So expect interest rates to escalate as well as savings rate.
Proliferated purchasing power due to firmer US dollar. Given that all things are on the same footing, let us assume the increase in rates is reflective of true interest rate hike if the inflation remain steady or falls. US investments will become more appealing to foreign investors; therefore, these foreign investors will demand more US dollars. The increased demand will lead to strengthening the greenback’s relative value. And a sturdier US dollar is tantamount to increased relative purchasing power for American consumers.
Lesser competitiveness for US manufacturers. Firmer US dollar in relation to other trading partners’ currencies negatively impacts the competitiveness of American manufacturers in terms of pricing. The cost of domestic inputs including cost of labor and office space, if valued in US dollars, will be higher than in the foreign counterparts of American firms. If such inputs comprise the main portion of general manufacturing expenses, US manufacturers will face higher overheads and overall production costs, hovering prices upward, compared with prices offered by manufacturers in other locations where its primary manufacturing costs may be priced in lower domestic currencies. Having the edge to price their products in currencies of a lower value, foreign rivals of American manufacturers can offer comparatively cheaper prices, making their products more attractive to US consumers than American-made goods. In the short-term, sturdier dollar will also influence US exports since a stronger greenback will lead to relatively higher prices for American products in the international marketplace. All else are equal, a sturdier US currency will give foreign manufacturers an advantage compared to US producers, at least in the short-term.