x Abu Dhabi, UAE Thursday 20 July 2017

Storm clouds in the East ominous for new Fed chief

Good bye Ben Bernanke and good luck to Janet Yellen. She's got a tough job ahead of her.

The most powerful woman in the world now is arguably a former economics professor past retirement age who this month became chair of the Federal Reserve.

Step forward Janet Yellen, successor to Ben Bernanke, the man now credited with saving the world from the global financial crisis a little over five years ago.

Not that this legacy is exactly secure. Larry Summers, who some feel ought to have replaced Mr Bernanke, told the World Economic Forum in Davos last month that the US economic recovery was “not strong enough”. These are words that could come back to haunt the writers of Mr Bernanke’s hagiographies.

Last May he first hinted that his QE money printing was going to be reduced gradually. Interest rates on US treasuries have almost doubled since then and globally interest rates have been on the up and up. Recently the Fed confirmed that the formerly $85 billion QE programme will be reduced by $10bn a month until it is closed down this October.

In global financial markets it is always the weakest link that breaks first. In the case of QE, money-printing trillions of dollars has found its way into emerging markets in search of higher investment returns. For when you earn almost nothing on US dollar deposits, the higher returns available in emerging markets look irresistible.

That inflow of money also brought interest paid on emerging market bonds lower and it fuelled up these economies in a self-fulfilling prophecy. However, what happens when you turn off this rocket fuel? The lights have started to go out in Buenos Aires, Brasilia, Mumbai, Moscow, Istanbul and Jakarta.

Across the emerging markets there is now currency devaluation after currency devaluation. Turkey doubled its interest rates late last month. Higher interest rates depress business activity. Devaluation is good for exports but bad for inflation. Overinflated local stock markets have come crashing down.

But the problem is not just confined to these countries. The world’s second largest economy is getting closer and closer to a serious credit event. Its $24 trillion credit system is bigger than the banking systems of the US and Japan combined.

China printed money equivalent to half its GDP in 2009 in the biggest monetary expansion in history. Money has been lost on an epic scale through investments in uneconomic prestige projects. If you are looking for an equivalent to Lehman Brothers and the subprime crisis of 2008 that brought us the last global economic crisis then “Made in China” is stamped on it.

At the same time Japan has embarked on a money-printing experiment of its own known popularly as “Abenomics” after its prime minister. For good measure it is actually the biggest such programme per capita in the world, spending more than twice the amount of Mr Bernanke’s QE per person.

One of its key aims is to weaken the yen to make Japanese exports competitive. Just a shame then that the crisis in the emerging markets has boosted the yen as a safe haven. If the Chinese economy blows up it will certainly take Japan down with it.

So welcome to your new office, Mrs Yellen. You’re likely to face some of the greatest challenges ever in the history of central banking. Will you be up to the task? Is the US economy “strong enough” to meet these headwinds?

Wall Street has been helpful so far. Instead of crashing on the news of higher interest rates equities roared higher with an exit from bonds. It’s what Austrian economists call a “crack-up boom”, a final spike in asset prices into a massive bubble. Technical chartists say they have seen nothing like this since 1929 and the Wall Street Crash.

What will Mrs Yellen do if a correction gets out of hand? Her past form is very much as a money printer. She once argued in the last crisis for negative interest rates. So once the creative destruction of a correction is done the Fed is likely to revive QE money printing with a vengeance.

Except that QE suffers from something called the law of diminishing marginal returns. In short, the more you do it the less effective it becomes. What will Mrs Yellen do then? We can only hope she has an answer.

Peter Cooper is editor of arabianmoney.net