Sunday 18 March 2018

So is a taper really just a tightening? The Fed says no, but we're about to find out


Alan Greenspan, former chairman of the U.S. Federal Reserve, left, chats with Ben Bernanke, the current Fed chairman
Alan Greenspan, former chairman of the U.S. Federal Reserve, left, chats with Ben Bernanke, the current Fed chairman

James Saft

The coming months will answer decisively a question the Federal Reserve insists is already settled: is a tapering a tightening?

Score one for the Fed came last month when it cut purchases of bonds to a monthly $75bn from $85bn, but paired the move with a confection of sweeteners which touched off a startling rally in equities and only a small increase in long-term interest rates.

"Tapering is not meant to be a tightening," Mr Bernanke said after the Federal Open Market Committee announced the move. "The Federal Reserve means to keep the level of stimulus more or less the same."

To judge by the reaction of the stock market, the moves the Fed announced must qualify as a loosening.

That may be because in addition to shaving $5bn per month off of the amount it buys of both Treasuries and mortgage bonds, the Fed hardened forward guidance to indicate that rates could remain near zero "well beyond" the time unemployment drops below 6.5pc.

That depends, in part, on inflation continuing to run below the Fed's 2pc target.

That's quite a nice little bonus, considering that the Fed's own forecasts don't see much danger of inflation going above 2pc for several years. Traders are betting that the first rise in interest rates isn't until July of 2015.

Mr Bernanke also indicated that, if things roll along as he expects, they'd do about a $10bn decrease per meeting, implying that we'll be all done with large-scale asset purchases by the end of this year.

Zero interest rates are one thing, but market rates are quite another, and as the Fed decreases purchases, longer-term rates are likely to rise.

Investors who get cash from the Fed for their bonds become more willing to take risk. As the Fed buys fewer bonds and gives out less cash, that risk-taking preference will diminish. That is a tightening and that tightening will have consequences.

That, in fact, is exactly what happened last summer, throwing a scare into risk markets, particularly emerging markets, and ultimately leading to the famed non-taper of September.

Some things have changed between September and now. The fiscal drag on growth looks less frightening this year, employment is firming and manufacturing, by and large, is doing well.

All of those factors, however, are vulnerable to a rise in long-term rates.

The economy can withstand that tightening only if business investment kicks in and businesses start to invest in earnest, driving wage growth and employment. Gently highering long-term rates combined with more business investment would be positive, indicating a return to healthy growth. It would also drive inflation a bit higher, perhaps allowing the Fed to gracefully exit zero rates earlier than planned.

Based on the track record in recent years, none of this is assured.

So, if the economy does not kick it up a gear and the Fed carries on tightening while promising low rates for longer, who and what suffers?

First, housing. Mortgage rates will rise, especially given the hit to Fed mortgage bond buying. That will hurt the minority of actual owner/occupiers who are in a position to move financially. Higher long-term rates will raise the returns investors expect from housing, undermining the bid single-family houses have had from financial investors. I'd look closely at housing next year as mortgage rates go up.

Second, bond markets. Public bond markets are undeniably loose, with a huge erosion of terms and conditions also under way in private lending markets. That has kept weak businesses alive and helped to underpin returns from related markets like equities.

The taper spells an end to that, one way or another. Investors will have less cash on hand, marginally, and will be less willing to invest in a Payment in Kind note or junk bond. Again, if this happens while growth and investment take off, it will be fine. Some weak companies will fail, but many will improve in credit quality.

If it happens with growth still weak and investment low, an ugly cycle of tougher credit conditions, tough business conditions and more failures will ensue.

Let's wait a couple of months before we judge the taper's impact and what exactly constitutes a tightening. Fed chairwoman Janet Yellen may have a tough first year as chair in store.

Irish Independent

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