From Tapering to Deflation?
The Federal Reserve System’s long dreaded taper fade has finally been announced. After leading on the markets for some time now, the fed-heads in charge of printing and minting currency, along with confidence, have decide that the time has come for a multi-billion dollar taper fade to be implemented.My friend Brian Romanchuk, author of the Bond Economics blog, had this to say on Taper! Taper! Taper!:
Stocks have shot up on the news that fed-heads in charge of the Federal Reserve System have actually decided to take on the taper that they’ve been hinting would eventually happen. The reasons cited by the money wizards behind the curtain were that we now have a stronger economy, which among other things signals an appropriate time to begin scaling back the $85 billion a month bond purchase stimulus to something more conservative. The more conservative figure that has been agreed upon is a taper fade special of $10 billion a month, leaving the new monthly bond purchases at $75 billion.
Investors had for quite some time been frustrated at the wishy-washy position taken by the fed-heads, namely Bernanke, regarding whether or not the time was right to implement the taper they had talked about for so long. Now, as news of the decision to finally taper begins to circulate, the markets reaction shows how investors feel about the Federal Reserve System’s decision. The stock surge can be interpreted as a sort of digital smile, wink, and hair-toss from investors back in the direction of the fed-heads who have been leading them on for so long.
The Dow jumped more than 200 points in less than one hour after the announced taper, whereas just prior to the taper announcement the Dow was only up a mere 47 points. The S&P 500 along with Nasdaq followed suit, rising 1.0 percent and .05 percent respectively.
The $10 billion taper fade is set to begin in January, but already has shown itself to be a welcome bit of news to investors. The Federal Reserve System’s financial wizards seem to be making a statement with the recent decision. The announcement may seem to imply that the recent actions are a sign of good faith tossed across the bow to investors who had been getting tired of having their expectations and feelings disregarding by all the unexpected pivots by fed-heads regarding the implementation of the mythical taper.
The decision to taper now comes as somewhat of a surprise to investors, though not totally unexpected as Bernanke had clearly been tossing the decision around for some time. What appears to have taken some by surprise is the timing of the decision, which most expected to be made after the first quarter of 2014.
It appears as though the decision to taper will be supported by the incoming fed-head Janet Yellen. Ben Bernanke, in a recent statement made to the press, made it clear that he had consulted with the incoming leading lady of banking, and that Yellen “fully supports” the decision to taper.
The timing of the decision has translated into a nice boost to the markets as the fiscal years draws to a close, and with the response, it is clear that investors view the decision in a somewhat positive light.
As the statutory stitching that holds together the precarious global economic system gets pressed, every bit of confidence is sure to go a long way for the fed-heads and financial engineers in charge of maintaining the domestic and international money-go-round. This latest action will presumably buy the necessary confidence to keep the engine running until further notice.
The future remains unknown, but today’s news is that the Federal Reserve System’s mythical taper has finally arrived to the tune of $10 billion a month.
Well that was exciting. So far my forecast that this would be viewed as a policy error was wrong, but in my defense, it's too early to say...There were a lot of "howevers" in the last paragraph but I too was a bit surprised by the Fed's decision to begin tapering at the end of the year. As I stated in my last comment on the Dectaper surprise, the threat of global deflation is huge, which is why I thought the Fed would not start tapering at this time.
The key points to note:
My reading is that the baseline scenario should be:
- Fed monthly purchases drop by $10 billion to $75 billion per month; $5 billion each from Treasury and mortgage paper;
- ignore that 6.5% unemployment rate triggering rate hikes thing; rates can remain at zero as long as inflation is well behaved.
This appears slightly more hawkish than what is priced into the forwards, but not by much. However, it seems consistent with the published consensus FOMC forecasts. The Fed wants bond market participants to believe that there will be a lengthy pause in between the end of QE and rate hikes, but we do yet not have enough information to believe them. However, it appears that risks may be skewed towards the Fed being less hawkish than this baseline, explaining why forward rates are below what the path of Fed funds it implies.
- Purchases reduced by $10 billion at each Fed meeting in 2014. This means that the end of 2014 is the end of QE (there are 8 Fed meetings per year).
- Fed rate hikes commence shortly thereafter (early 2015).
The initial financial market reaction was entertaining. So far, equities are up on the news. There goes the forecasts that "the Fed can never Taper because of stocks". However, it may be possible that the initial reaction is an incorrect read on future trends. However, it is nice to see the Fed having the will to act in December, despite the worries about the reaction of illiquid markets. The Fed needs to break its reputation of kowtowing to the needs of the equity markets.
I was less surprised, however, at the initial knee-jerk reaction of the stock market. As I predicted, stocks melted up. We are still in the early innings of a major liquidity melt-up and even if the Fed tapers by $10 billion at each of its meetings in 2014, stocks and other risk assets are headed much higher, fueling more bubble anxiety among jittery investors.
But the key question is why did the Fed start tapering? Sure, the U.S. economy has recovered but it's a long way from where it was before the crisis hit. Moreover, the gains have been very uneven, with the rich getting richer while most people struggle to make ends meet.
Over in Europe, Draghi is trying to calm fears of deflation, but he better heed the advice of Barry Eichengreen and start cranking up quantitative easing. In Japan, the government is prematurely dropping the word "deflation" from their monthly economic report, foolishly believing they've escaped years of price declines.
Last month, the OECD's chief economist said current European policies are pushing a string of countries into deflation and onto a much lower growth path and warned the global economy remains extremely fragile, highlighting the danger of "virulent episodes" in emerging markets as the US Federal Reserve starts to withdraw global dollar liquidity.
So what gives? Why did the Fed begin tapering? Is this going to be another major policy blunder? To answer this question, let me once again refer to Mike Whitley's excellent comment in counterpunch, The Truth About Deflation, where he notes:
The Fed is stuck in an ideological cul de sac mainly because its members ascribe to Bernanke’s monetary theories which simply don’t work. Here’s a clip from a speech the Fed chairman gave to the National Economists Club in 2002 that gives us a glimpse into his thinking:
“Under a fiat money system, a government… should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.” Ben S. Bernanke, “Deflation: Making Sure It Doesn’t Happen Here”, Federal Reserve, November, 2002
Okay, so where’s the inflation, Ben? The Fed’s 2 percent inflation target continues to move farther away the longer the Fed’s programs stay in place. Even more shocking is the fact that “The Fed’s preferred measure of U.S. inflation, the personal consumption expenditures deflator (PCE), showed last week that prices rose 0.7 percent in October, the least since 2009.” (Bloomberg) So even by the Fed’s own standards, QE and zirp have been a bust.
The reason for this is simple: QE does not raise inflation because QE does not increase incomes, wages or credit. The reserves that are created via QE remain in the banking system where they buoy asset prices by reducing the supply of stocks and bonds available for sale. But there is no transmission mechanism for delivering money to the real economy where it can increase activity, inflation and growth. The fact is, QE may actually be deflationary since it reduces the interest on bonds (US Treasuries) that provide income for savers and other fixed-income investors. Some analysts put the amount of potential savings lost due to QE in the neighborhood of $400 billion, which represents about half of all the money spent on Obama’s fiscal stimulus called the American Recovery and Reinvestment Act of 2009. Naturally, the loss of this revenue has only added to the sluggishness and stagnation of the US economy.
Economist Frances Coppola believes that QE is “deflationary rather than inflationary”, and makes the case in a recent post on her blog titled “Inflation, Deflation and QE”:
“Both UK and US governments believe that monetary tools such as QE can offset the contractionary impact of fiscal tightening. But this is wrong. Fiscal tightening principally affects those who live on earned income. QE supports asset prices, but it does nothing to support incomes. So QE cannot possibly offset the effects of fiscal tightening in the lives of ordinary working people – the largest part of the population. In fact because it seems to discourage productive corporate investment, it may even reinforce downwards pressure on real incomes. And when the real incomes of most people fall, so does demand for goods and services, which puts downward pressure on prices, driving companies to reduce costs by cutting hours, wages and jobs. This form of deflation is a vicious feedback loop between incomes, sales and consumer prices, which in my view propping up asset prices can do little to prevent.” (“Inflation, Deflation and QE”, Frances Coppola, Coppola Comment)Coppola, who calls QE “one of the biggest policy mistakes in history,” backs up her claim with a number of charts and graphs which show how inflation fell during periods when central banks were buying sovereign bonds and boosting reserves at the banks. (Remember, the point of QE is to raise inflation expectations, not lower them.) Her repudiation of QE is further underscored by the fact that the so called “velocity of money” has dropped to a six decade low. Get a load of this graph from the St Louis Fed (click on image):
I agree, deflation is coming but it doesn't have to be a bad thing. As far as tapering, maybe the Fed took a look at the work of Frances Coppola and decided that QE wasn't stoking inflation expectations, it was actually pushing them down. So they decided to begin tapering hoping inflation expectations will rise. But if rates begin rising too fast, debt-laden consumers will be crushed, virtually ensuring a viral bout of debt deflation.
According to Investopedia the “velocity of money” means: “The rate at which money is exchanged from one transaction to another, and how much a unit of currency is used in a given period of time…Velocity is important for measuring the rate at which money in circulation is used for purchasing goods and services. This helps investors gauge how robust the economy is, and is a key input in the determination of an economy’s inflation calculation.”
Bernanke knows that velocity is in the doldrums and that QE has had no meaningful impact on activity. Keep in mind, these are the Fed’s own charts. All the members of the FOMC are familiar with them and know what they mean. And what they mean is that the money is going no where; it’s stuck in the financial system goosing asset prices and providing needed balm for bloody bank balance sheets which are still deep in the red five years after Lehman Brothers collapsed. In other words, QE is working largely as it was designed to work. It is boosting profits for the financial sector while keeping the real economy in a permanent slump. As long as the economy underperforms, the Fed will have a reason to continue the existing policy. If, however, the economy gains momentum and inflation rises, the Fed will be forced to wind down its asset purchases and raise rates cutting off the flow of interest-free money to the banks. Thus, the Fed’s strategy requires that the US Congress and the White House continue to shave the deficits, curtail public spending and implement other belt-tightening measures to make sure the economy does not rebound and upset the Fed’s plan to continue its wealth transfer to Wall Street.
This sounds easier than it is, in fact, the droopy rate of inflation suggests that Bernanke may already be too close to the cliff-edge to pull back in time. Credit growth, personal consumption, wages and incomes remain either flat or trending lower. The recent bump in Third Quarter (3Q) GDP was largely due to one-time inventory buildup that will undoubtedly weigh heavily on future readings. The same rule applies to unemployment where the uptick in payrolls is overshadowed the bleak participation rate which continues to reflect the abysmal state of the labor market. Also, the New York Fed just released a report (FRBNY Survey of Consumer Expectations: Household Finance Expectations) showing that “both household income growth and spending expectations are basically flat-lined (and) that there is no expectation of things getting any better or any worse.” (Housingwire) Needless to say, when consumers are as pessimistic as they are today, it greatly impacts their spending habits. (which the survey confirms)
Finally, the US economy is bound to be wacked by Japan’s accelerated QE program which has slashed the value of the yen weakening US exports while pushing up the value of the dollar. Like the Fed, the Bank of Japan is following a beggar-thy-neighbor policy which exports deflation to its trading partners in the relentless pursuit of aggregate demand. This is how currency wars start.
All of these are adding tinder to a woodpile that could burst into flames in 2014. CLSA’s prescient analyst, Russell Napier, believes the world is about to experience a “deflationary shock” that will send raw materials, manufactured goods, and stocks plunging. Here’s a short excerpt from his article titled “An Ill Wind” via Zero Hedge:
“Three times since 1997 inflation has fallen below 1% with very negative impacts for equity investors. On all three occasions an existing low level of inflation was forced lower by dramatic events: the bankruptcy of Russia and collapse of LTCM in 1998; the terrorist attacks of 11 September 2001; and the bankruptcy of Lehman Brothers in September 2008. While nobody would attribute the 11 September atrocity with extant global deflationary forces, the other two episodes can clearly be associated with such forces. So perhaps it is global deflationary forces creating a bankruptcy event, somewhere in the world, that is the catalyst for a sudden change in inflationary expectations in the developed world. It can all happen very quickly; and it is dangerous to stay at an equity party driven by disinflation when it can spill so rapidly into deflation.
In 1998 falling export prices triggered a Russian default, and in 2008 falling US house prices triggered the Lehman bankruptcy. Going back further, deflation in the oil price in 1982 produced a Mexican default and a credit event which threatened to bring down the US banking system. Deflation in these key prices produced a credit event which rapidly produced a major reassessment of the outlook for the general price level. Across the world today we see falling commodity prices and, primarily due to the weak yen, falling manufactured-goods prices. When there is plenty of leverage in the system and any key price starts to decline then a credit event and a sudden change in inflationary expectations are much more possible than the consensus believes.” ( “An Ill Wind”, Russell Napier, CLSA, selected excerpts, zero hedge)
The threat of deflation is quite real, in fact, it’s probably just one bank failure away.
Below, Steve Schwarzman, Blackstone Group chairman, CEO & co-founder, shares his thoughts on the Fed's taper decision and provides and shares his outlook on the 10 -year Treasury yield and housing. "We are the largest owners of homes in the U.S.," Schwarzman reveals.
He better pray deflation doesn't rear its ugly head before they unload all those homes. I'll tell you who else is screwed if deflation is in the offing, pensions praying for an alternatives miracle.