The timing of the Fed’s taper may be dominating current debate but the better question may be “what’s next?”
Attempting to predict when the Federal Reserve might begin the tapering of QE has consumed untold hours of spirited debate. Are investors wise to partake in a guessing game in which the majority of the eventual decision makers are themselves undecided?
Probably not. If reducing Treasury and mortgage bond purchases known as QE is inevitable, the timing of the first reduction will be largely immaterial.
Of greater interest is why purchases may be tapered. I submit the rationale will not be the emergence of a “robust” economy as hoped by the Chairman-elect. Instead, regardless of the rationale offered publicly, the Fed is likely to walk away from the monthly bond purchases we’ve become accustomed to because it is simply ineffective at meeting its stated objectives – or put more judiciously – failing to offer an economic benefit worthy of the burgeoning experiment’s risks.
Under such a scenario committee members have suggested via meeting notes released this week that “it might well be appropriate to offset the effect of reduced purchases by undertaking alternative actions to provide accommodation at the same time.”¹ In other words, if bond purchases are tapered, the Fed may consider something else to take its place.
The first tool to be introduced is that of “forward guidance.” The Fed has, and will likely continue to place a greater emphasis on their pledge to keep short-term interest low for the foreseeable future.
For clues as to even bolder alternative actions we return yet again to Chairman Ben Bernanke’s speech of eleven years ago today. The speech reads like the Old Testament, listing potential monetary policy responses once interest rates have been reduced to zero. With most of those ideas having been exhausted in recent years, what’s next for the Fed to try?
- The Fed could “expand the menu of assets that it buys.”² State, municipal and/or foreign debt may fit the bill.
- The Fed could enact an interest rate cap, adopting a pledge similar to the European Central Bank to enter the market and buy unlimited quantities of the Treasury’s debt to effectively establish a ceiling on interest rates.
- The Fed could lend to banks at 0% and accept “corporate bonds, mortgages”2 as collateral. Doing so would reduce corporate borrowing costs even further – and add a few more dollars to bank’s bottom line in the process.
- The Treasury could issue debt to buy private assets. The Fed could print dollars to buy the Treasury’s debt.
If the potential further expansion of monetary policy appears far-fetched, readers are reminded when similar sentiments preceded earlier experimentation.
I will leave it to others to craft a catchy description if the Fed elects for a new iteration of “Plan B.” Regardless of the nickname or advertised benefits however, it is time for investors to wizen up. While the Fed’s creativity for manipulating markets is admittedly intriguing, the Fed has limitations. Despite continued suggestions to the contrary, they probably can’t tame the business cycle and it is questionable if increasingly bolder measures can generate meaningfully higher employment.
Undoubtedly markets have benefited from overly accommodative monetary policy to date. The adoption of even bolder measures may well usher in renewed enthusiasm. In the absence of meaningful economic benefits however, the prudent investor must acknowledge that “alternative actions” may further complicate the eventual unwinding and raise the risk of adverse consequences. At some point a sober reevaluation of the central bank’s underlying credibility appears warranted as well.
1 – Federal Reserve, “ Minutes of the Federal Open Market Committee October 29-30, 2013 http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20131030.pdf
2 – Bernanke, Ben S, “ Deflation: Making Sure “It” Doesn’t Happen Here” Web 21 November 2002 http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/