The taper weight

With the benefit of hindsight it’s clear that the Federal Reserve Board’s statement on May 1 was a turning point for global markets.
 
It might also have been a turning point for governments around the world.
 
The so-called “tapering” of the Federal Reserve’s massive money printing program in the months ahead will cause some market volatility, but it also signals the return to health of the world’s economic superpower and puts great pressure on other countries to get their act together.
 
There wasn’t much of a change in the Fed’s language at the beginning of May, merely the addition of these words: “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.”
 
Nevertheless, global bond markets had their worst month in nine years in May and equity markets shifted from chasing defensive yield stocks to cyclicals. Australian bank stocks fell 10 per cent in May while BHP Billiton rose 8.5 per cent. Equity markets generally turned lower as well after Fed chairman Ben Bernanke confirmed that the pace of bond purchasing could be reduced “in the next few meetings”. 
 
So that subtle shift in the Fed’s language – suggesting that it might stimulate a little less vigorously in the months ahead – has ended the bond bull market, sent the US dollar higher and produced a turning point in the stock market.
 
It was a bit like a central bank saying, after a run of 50 basis point rate cuts, that it was only going to cut by 25 basis points from now on.
 
The key for governments is the rising US dollar. It has now appreciated 6.5 per cent against a basket of currencies since the start of February, 3.3 per cent in May. Against the Australian dollar, the greenback is up nearly 7 per cent in May alone.
 
It should mean that governments no longer have to work hard to get their currencies down: the co-called currency wars can end because America has ‘won’ by being the first to let its currency rise.
 
But it’s a double-edged sword, especially for Australia. The combination of the rising US dollar and slower Chinese growth, leading to a fall in Australia’s terms of trade - the iron ore spot price has already fallen 31 per cent since mid February - could see a rapid depreciation of the Australian dollar in the months ahead.
 
That would be great for the competitiveness of Australian manufacturing but a falling currency and terms of trade also leads to a decline in national income. Input prices rise and government revenue falls.
 
In 1986, when the Australian dollar fell below US50c, the nation was forced to embark on two decades of microeconomic reform to boost productivity, as well as deliberately cause a recession in 1991 to reduce inflation.
 
The main reason Australia has not had a recession for 20 years is not the direct impact of China, but the fact that the rising dollar has kept inflation between 2 per cent and 3 per cent for most of the time, allowing the real cash rate to trend down since 1994.
 
A depreciation of the currency now would end Australia’s unbroken 22-year record of economic growth as night follows day.
 
It would also force a return to difficult microeconomic reforms to boot productivity. With rising terms of trade and exchange rates, the only source of rising national income would be productivity.
 
Trade exposed firms have had to increase productivity over the past few years to deal with the high exchange rate, but others have grown fat and lazy.
 
Construction and government in particular need reform. Building costs have been rising rapidly in recent years and resource project developers are no longer just complaining – they’re pulling out. 
 
Australia is not alone in this. Japanese PM Shinzo Abe is pushing structural reform as well as aggressive monetary stimulus; the new Chinese leader Xi Jinping is talking about dramatic reforms in China; the future of Europe depends on microeconomic reforms boosting the competitiveness of nations like Italy, France and Spain.
 
Perhaps the only country to get leave pass from microeconomic reform now will the United States, thanks to a rising currency, cheap energy and a rapidly recovering housing market.

Alan Kohler will be hosting two Ashes lunches with Gideon Haigh and Stephen Fay (former editor of Wisden and author of books about The Bank of England and the collapse of Barings) on June 25 in Sydney and June 26 in Melbourne. To book a table click here.

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