The Dectaper Surprise?
The main question this year about the Federal Reserve’s extraordinary easy-money policy has been when it will begin curtailing $85 billion in monthly purchases of bonds. If it doesn’t happen soon, at the end of the Fed’s in-progress mid-December meeting, the betting money is on a decisive move at the gathering in March.The comment above raises some interesting points but I think Newman is overly complicating things. First, he's right, the Fed could change the way it purchases bonds. It could even start buying corporate and municipal bonds once it's done buying up all those Treasuries, but that is highly unlikely.
But that binary set of options — "tapering" or not, to use Wall Street’s overworked term — is a vastly oversimplified view of the Fed’s options.
Many critics feel quantitative easing, as the Fed’s bond-buying policy is known, has failed to achieve its goal of jump-starting the economy and helping create jobs, even though the unemployment rate has fallen from a peak of 10% in 2010 to 7% today. Those folks would like to see the policy rolled back as quickly as possible, since it may be contributing to an overinflated stock market and other economic distortions.
However, the intense debate over the virtues of quantitative easing and the rollback schedule, whatever it turns out to be, has drawn attention away from other tools the Fed could use. "The Fed has many more options than any of us can contemplate," says Peter Fisher of investing firm BlackRock.
In fact, the Fed may introduce new "offsets" to soften the impact of a policy change at the same time it decides to tighten up on quantitative easing. Here are some of its alternatives:
Change its quantitative easing targets. The market presumption seems to be that once the Fed cuts back, it will reduce its $85 billion in monthly bond purchases by a similar amount each month — say, $10 billion — until they fall to $0. But it could also change the way it purchases bonds. The Fed could say it will purchase a fixed amount of bonds, for example up to $500 billion worth, but on no fixed schedule. Or, it could say it will buy bonds until some future deadline, such as the end of 2014, but not say how much.
The purpose would be to gradually tighten policy while still reassuring financial markets it intends to help the economy. Fine-tuning the amount of bond purchases and the exact timing would help send the desired message (if it worked).
Change the threshold for tightening. There are two key components to the Fed's easy-money policy: quantitative easing (which pushes long-term interest rates down) and low short-term rates, which the Fed controls directly with the fed funds target rate. The Fed has said it will keep short-term rates near zero until the unemployment rate hits 6.5% or lower, as long as inflation remains below 2%.
It could easily change either of those targets, or tie a policy change to other indicators, such as unit labor costs or the average length of the workweek, so the decision would be based on a fuller view of labor market conditions. Any move along these lines would be meant to signal the Fed will keep rates low for longer than currently expected, making for bullish news for borrowers and investors.
Lower the interest rate the Fed pays banks. Commercial banks have about $1.6 trillion in accounts at the Fed, which is paying them an interest rate of about 0.25%. That’s obviously very low, but in normal times, the Fed pays no interest on deposits. For banks, the ability to earn $2.5 million per year for every $1 billion on deposit at the Fed, with no real risk, has persuaded them to leave most of that money there.
If the Fed lowered its rate to 0%, banks would be more inclined to lend their money and pursue profit that way. That would risk higher inflation, since more money would be flowing into the real economy, but it would also generate more economic activity, since most borrowed money gets spent.
Provide clearer "forward guidance." One mistake the Fed made in 2013 was signaling that a policy change would be coming soon, which drove up rates in May and June, then reversing course, as the threat of an October government shutdown became more dire. The Fed, if it chose, could be much more specific and far less cryptic about its plans, by spelling out exactly what it plans to do, and when, instead of leaving everybody guessing. The tradeoff would be less flexibility to change its policy and lost credibility if it didn’t do what it promised.
Aside from the many technicalities of monetary policy, the Fed has the tricky job of trying to gauge the way markets are likely to react to any policy change, along with how much it matters. The Fed would never say this, but it's been deferential toward market sentiment during the last five years, perhaps because the central bank realizes that confidence or distrust in the economy can sometimes be as powerful as actual conditions. To some critics, that amounts to coddling, and it needs to end.
"The Fed wants to wind down purchases," says Alan Levenson, chief economist at investing firm T. Rowe Price. "It will start reducing asset purchases when it finds a way to strengthen interest rate guidance to soften the blow."
If you get the message the Fed most likely intends to send, you'll breathe a sigh of relief, hold onto your stocks and perhaps buy more. And whether you interpret the Fed's actions in a benign or alarmist way probably matters a lot more itself than when it is you do it.
Second, even if the Fed lowered its interest rate to zero, banks would not crank up their lending activity. Why? Because banks borrow for nothing, lock in spread and are making a killing trading risk assets. They're not interested in lending money to small and medium sized businesses and the Fed knows this and is even encouraging their risk-taking behavior.
Third, the Fed has provided very clear guidance, at least in my mind. Importantly, its actions since the crisis erupted back in 2008 have signaled that it and other central banks will do whatever it takes to reflate risk assets and avoid a prolonged debt deflation cycle. It's all about big banks, inflation and corporate profits. The Fed couldn't care less about employment and the real economy. If this is what you think, you've been reading the Fed all wrong and losing big money in the stock market.
The problem is the Fed and other central banks are losing the titanic battle over deflation Mike Whitney wrote an excellent comment for counterpunch, rightly noting deflationary pressures are greater today than anytime since the end of the recession in March 2009. He ends with an ominous warning: "The threat of deflation is quite real, in fact, it's probably just one bank failure away."
So, you can read all about why Goldman Sachs thinks the Fed won't taper in December or keep in mind the comments above and remember what I told you back in June, fears of Fed tapering are overblown. As long as the threat of deflation persists in the U.S., Canada, Europe, and emerging markets, you can forget all about tapering. In fact, I agree with Barry Eichengreen, the ECB should crank up its quantitative easing to combat the risk of deflation (gold will rocket higher when the ECB moves).
I, along with many others, were caught off-guard by the Septaper surprise, focusing too much on the U.S. economic recovery and not enough on the real threat of an emerging markets crisis and European deflationary bust. Will the Fed surprise us once more in December? I strongly doubt it and think even the hint of tapering will wreak havoc on global markets and the global economy.
And what if the Fed does begin tapering? Bank of Canada Governor Stephen Poloz told Reuters on Tuesday that investors understand the Fed's thinking much better than they did when Chairman Ben Bernanke first mentioned the possibility of tapering the U.S. central bank's $85 billion in monthly asset purchases on May 22, and he isn't concerned about market volatility.
My take? If the Fed does taper, which I strongly doubt given global deflationary pressures, I think markets will plunge as yields back up, but you have to buy that dip because the stock market bubble is just taking off. There is so much liquidity in the global financial system and a bit of tapering won't change the trajectory of risk assets. They're going much, much higher.
(My Christmas gift to you:
Below, Michael Gayed, Chief Investment Strategist at Pension Partners, explains how 2014 might play out given the big disconnect between what stocks think and inflation expectations. I don't agree with Michael on developed markets going forward because I think we're in the early innings of a major liquidity melt-up but I'm cautious on emerging markets, fearing a crisis is in the offing, especially if the Fed starts tapering (I strongly doubt it).
Update: In what amounts to the beginning of the end of its unprecedented support for the U.S. economy, the Fed said it would reduce its monthly asset purchases by $10 billion, bringing them down to $75 billion. It trimmed equally from mortgage and Treasury bonds.