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The Taper That Wasn’t

The Federal Reserve announced yesterday that it would not, contrary to previous indications and the expectations of the entire financial world, begin to taper its “QE3” policy – an effort use U.S. monetary policy to stimulate the domestic economy through

The Federal Reserve announced yesterday that it would not, contrary to previous indications and the expectations of the entire financial world, begin to taper its “QE3” policy – an effort use U.S. monetary policy to stimulate the domestic economy through the unprecedented monthly purchase of $85 billion in mortgage-backed securities and Treasury bonds. According to the Fed announcement and the subsequent press conference comments of Chairman Ben Bernanke, the taper plan wasn’t put into effect because Fed officials think that the U.S. economy is – contrary to their expectations – still too weak, and that it might not be able to withstand any monetary tightening.

I will be the first to admit that I am not an expert in monetary policy, so I’m not going to sit here and pretend to know the precise effects of today’s announcement or even begin to judge the long-term effects of the Fed’s continued efforts, tapered or no. (And, frankly, you should be extremely skeptical of anyone – anyone – who claims to know these things with unflinching certitude.)  But, I do know a little about market fundamentals and basic economics, and I don’t think that any of that has changed… yet.

So, with that sheepish disclaimer, here are a few observations about the Fed’s big announcement:

First, while financial markets cheered yesterday’s non-move (more on that below), U.S. consumers should be wary due to the impact that the decision could have the value of the dollar (weaker) and commodity prices (higher).  As most people following this stuff understand, loose monetary policy – and the declining U.S. dollar that accompanies it – increase the dollar value of internationally traded commodities (e.g, gold, oil or corn) because more dollars are needed to purchase the same quantity of that commodity.  As a result, energy and food prices can spike, even though broader measures of inflation like “core CPI” remain tame.  (More on that here, if you’re interested.)  It’s still too early to know exactly what today’s announcement will do to, for example, gas prices, but the initial dollar and commodity movements weren’t good in this regard: the dollar weakened to a seven-month low against the euro, as gold and oil futures moved sharply higher.  Should these trends continue, U.S. consumers could be in for some serious pain at the pump and their local supermarkets.

Second, the extent to which U.S. and global markets depend on the views of a handful of men and women at the Fed is simply breathtaking and, for those of us who believe in the inevitable fallibility of the politico-expert class, should (in technical terms) freak the bejeebus out of you.  There is no better example of the upside-down state of our financial markets than the fact that the Fed’s announcement – which reflected a complete lack of faith in the near-term U.S. economy and a reversal of its near-unanimous views only a few months earlier – caused the stock market to soar.

As the Washington Examiner noted:

The Fed’s pause before tapering reflects the fact that the economy has not improved as officials expected it to in the weeks since its last meeting in July. Recent reports on the employment situation have disappointed, with jobs growth averaging under 150,000 for the past three month and the unemployment rate at 7.3 percent.

Due to this seemingly-depressing news – an indicator of the weakness of both the U.S. economy and the Fed’s prognosticative abilities – both the Dow and the S&P500 hit record highs!  And when the taper was first announced back in the spring (due to confidence that the U.S. market would hit its stride in the fall), markets here and abroad tanked, mortgage rates spiked and general gloom spread throughout Never Neverland (aka Wall Street).  Now, the last time I checked, stock markets traditionally cheered the good economic data and dropped on the bad.  But in the QE era, they’ve routinely done the opposite due to concerns over the effect that “good news” might have on monetary policy (here and elsewhere).  You don’t have to be an expert to know that this is not a sign of a healthy, stable market.

Third, and relatedly, the obvious and significant impact that the Fed’s QE policies have on global financial markets should raise concerns due to the Fed’s reliance on these very same data to determine its very same QE policies.  For example, consider the following circular statement from the WSJ: “Among the concerns about economic growth, the Fed in its statement highlighted higher mortgage rates, which have climbed more than a percentage point since May, when Fed Chairman Ben Bernanke first hinted the central bank could begin to scale back the bond-buying program.”

Translation: the Fed can’t taper now because of the harm caused by its original tapering announcement.  Umm, so when can the Fed taper?  And must it do so in a super-secret, surprise move, so as not to spook the very markets upon which said tapering is based?  And what does this do for the much-ballyhooed “forward guidance” (i.e., telling the markets precisely what market targets, like the unemployment rate, will trigger tapering)?  For example, if a 6.5 percent unemployment rate will trigger tapering, will markets freak out – and lead the unemployment rate back higher – if/when we approach that target, further delaying the planned tapering?

My head hurts.  (And how the Fed extricates itself – and the U.S. economy – from this sticky wicket is beyond me.  It doesn’t help, of course, that their goalposts appear to keep changing.)

Finally, it’s important to reiterate here that no one – not even the Fed itself – truly knows the long-term effects of QE on the U.S. economy.  Not only is QE3’s form unprecedented, but so is its sheer magnitude and the magnitude of the rest of the Fed’s interventions since the financial crisis.  Over that span, the Fed’s balance sheet has more-than-tripled to about $3.6 trillion, and over $800 billion of that is in assets purchased through QE3 over the last year or so.  Although this is only about 15% of the broader “M4” money supply, it’s still very significant.  And today’s announcement made clear that these huge, unprecedented moves aren’t ending anytime soon.  Maybe this giant injection of state money won’t have any long-term effects on the U.S. economy, but no one really knows.  I guess we’ll find out soon enough.

In the meantime, stock up on oil.

Follow Scott Lincicome on Twitter. All of Scott’s views on this site are his own and do not necessarily represent those of White & Case, LLP.

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