Why the Fed tapered asset purchases

Today’s commentary

Yesterday, the FOMC decided to reduce the pace of its large scale asset purchase program from $85 billion per month to $75 billion per month. The Fed has long wanted to taper its LSAP program and move to forward guidance to normalize policy but the data weren’t strong enough. Ben Bernanke pulled off this transition in masterful fashion, setting the stage for more market upside. Headwinds are building though. Building inventories, earnings disappointments and a lack of wage growth are my principal concerns.

The Taper Details

As I wrote in yesterday’s commentary, I had expected a December taper but my doubts on December tapering grew because hawks seemed to suggest tapering was wrong. Instead, the hawks believed the Fed should end QE aggressively or in one fell swoop. But as it stands, the Fed is set to end the QE program late into 2014 by pulling back the LSAP program in tiny steps. Here’s how the Fed addressed the issue in its statement yesterday. I have pulled out only the most salient points.

Information received since the Federal Open Market Committee met in October indicates that economic activity is expanding at a moderate pace…

…The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate… The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.

…in light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases. Beginning in January, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $35 billion per month rather than $40 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $40 billion per month rather than $45 billion per month…

…The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal…

…Voting against the action was Eric S. Rosengren, who believes that, with the unemployment rate still elevated and the inflation rate well below the target, changes in the purchase program are premature until incoming data more clearly indicate that economic growth is likely to be sustained above its potential rate.

Why Taper?

So what led us here? First, the Fed has long recognized that asset market froth is an outgrowth of accommodative monetary policy. Janet Yellen spoke to this regarding QE back in 2010. In fact, this is an instance in which the Fed wanted asset markets to rise, particularly housing as rising house prices would end household deleveraging as a threat to sustained recovery. QE2, operation twist, the Fed’s third round of easing focused on permanent zero, and QE3 were all undertaken because the economy fell out of bed and the Fed was concerned that deleveraging would tip the US back into recession.

We have to remember that fiscal policy has been unusually tight. Ambrose Evans-Pritchard called it “the most drastic austerity cuts since demobilisation at the end of the Korean War in the 1950s.” In the Fed’s post-tapering presser yesterday, Bernanke also remarked that fiscal policy had been a headwind.

And so the Fed believes that the fact that the US has had a recovery at all owes to monetary policy. He made this very clear during the presser, echoing remarks that he has made consistently over the past few weeks – I believe in part in order to cement his legacy as Fed Chairman. Ambrose agrees:

The diverging fortunes of the QE bloc and the EMU bloc prove beyond doubt that monetary stimulus packs a powerful punch. Without becoming entangled in the vendetta between Friedmanites and Keynesians – I value the insights both in the post-bubble phase, as well as “Austrian” insights before the bubble builds – the central bank experiment of 2008-2013 shows that blasts of money can greatly offset the pain of budget cuts, even when interest rates are zero. 

And I agree with Ambrose and Bernanke as well. The question is not whether one gets a recovery though. The question is the quality of that recovery and the secular durability of its roots. Unlike Ambrose, I do often quibble on this point, because fiscal policy is still neutered and QE-style monetary policy is emblematic of the trickle-down, asset-based economic model.

Putting this aside, the Fed became uncomfortable with QE as a policy too early in the year. Jeremy Stein led the way. But even Bernanke was uncomfortable with the market’s reaching for yield. So QE was killed. The question about the death of QE has never been an ‘if’ question; it has been a ‘when and how’ question. The Fed wanted to move to taper as quickly as possible but the backup in yields after even the mention of tapering was so devastating that tapering was delayed again and again. We’ve finally got it now though.

Why taper? What was so bad about QE from the Fed’s perspective? Bernanke told us frankly at the presser what the problem was in retrospect: the term premium.

Basically, the Fed was always concerned that QE had an immensely positive effect on risk-seeking behavior and in retrospect it seems like this ‘reaching for yield’ has been more than the Fed was comfortable with. Jeremy Stein told us in October that he doesn’t think that central banks should lean against asset bubbles. And Bernanke echoed this sentiment at the presser. Instead, Fed officials seem to believe that keeping asset prices in mind, monitoring them, and considering them as central banks make policy is a more appropriate response.

Moving from QE to forward guidance as the focal point of policy, while still remaining accommodative, accomplishes this. If you recall, the original response to tapering in May was violent. The Fed had already seen the reaching for yield, the currency war effect as hot money moved into emerging markets. But after tapering, we had this massive uptick in US yields that risked cratering the housing recovery and was also crushing EM as hot money fled. The Fed legitimately feared another recession and perhaps even a crisis. This after merely suggesting QE was going to be reduced, not ended.

It was interesting to hear Bernanke discuss this yesterday. The May incident taught the Fed that it was making the right choice. QE was combustible stuff for the markets and Bernanke yesterday pointed at the term premium for why. He basically said that QE monkeyed with the term premium instead of with forward rate expectations, and thus had a disproportionately large impact on risk-seeking behavior. Bernanke was saying that the Fed was more comfortable altering forward rate expectations than the term premium because doing so created a more balanced trade-off between positive effects of monetary policy on the broader economy and the negative effects of reaching for yield and risk.

Reacting to the news

I was keen to listen to Bernanke in his last press conference as Fed Chairman and I felt he said a lot of things candid things about the Fed’s world view that give us a better picture of US monetary policy. Let me run through them via my live tweeting from yesterday and some additional commentary.

Let’s start at 2PM when the Wall Street Journal’s David Wessel tweeted this:

Basically this means that the Fed has effectively changed guidance. The Fed sees full employment only by 2016, which thus means zero rates until that timeframe.

The hawks lost. They wanted a taper cliff, which meant QE for longer without tapering the pace but then an aggressive wind-down. The Fed’s response is more dovish i.e. it is a slower wind-down mixed with more doish forward guidance. It is this combination that caused markets to rally.

The elephant in the room that tells us the Fed wants to taper is disinflation. Inflation is falling everywhere, not just in the US. And yet the Fed is moving away from QE. That’s telling.

This was what I had to say before the press conference began.

Listening to Bernanke

Once Bernanke started to speak, he brought a lot more into view.

To me, this is the key that tells us the Fed’s satement was dovish and it may be for this reason the market rallied. Before Bernanke started speaking the Dow was up 200 points. It continued to rally into the close – a very bullish sign.

This should confirm for you that the Fed wanted to taper and were just looking for the best opportunity to do so when the data were more accommodating.

OK now, this next set of tweets is important because here Bernanke was calling QE a “secondary” and “supplemental” tool, suggesting that forward guidance is the main unconventional monetary policy tool. This was the first I had ever heard the Fed talk this way. And it bears noting. Bernanke was basically saying, QE is an enhancement, a supplementary measure we take to signal even more policy accommodation than our forward guidance does.

From now on we have to think of QE as an extra boost and forward guidance as the main tool as the Fed normalizes policy. The pace of QE simply signals more policy accommodation and thus is expected to have a disproportionately large impact on the term premium.

Another factoid that Bernanke threw in regarding QE is that we have had as much remittance of interest income to the Treasury since QE began as we had for the whole period in the 1990s and 2000s before QE began. I don’t remember the dates Bernanke used to make the comparison but I believe he said 1990-2007. I don’t know why Bernanke was telling us this. However, my takeaway is that it does highlight how much interest income QE has taken out of the private sector, adding a net ‘fiscal’ drag to the economy that is very much a part of why the deficit has closed so aggressively.

Bill Gross then goes on to note that the Fed has basically told us that short-to-medium term Treasuries are a safe play.

Gross is using this to shorten duration in anticipation of a coming risk-off move but punters can use this to feel comfortable leveraging up using shorter-dated paper collateral. A big takeaway from the presser then is that while tapering should signal risk-off, it won’t because forward guidance has been enhanced and extended and that is a big risk-on signal.

It was a masterful presentation by Bernanke that will have him leaving on a high note.

What Next?

I believe the market could continue to vault higher on the back of the risk-on signal that Bernanke gave. But I think this is the wrong takeaway from the Fed’s move. Tapering is the first move in a policy normalization cycle and it definitely should signal risk-off.

Moreover, the data are not strong enough to support this normalization. As much as I am against QE, it’s clear that if you have inflation falling as it is right now, it’s difficult to justify normalizing policy. The Fed may come to regret doing so. Furthermore, just as I started writing these words, I caught the jobless claims data coming in. They were terrible: 379,000 claims with the 4-week average up to 343,500. What I believe is happening is that earnings are weak and inventories are high. Companies are starting to realize that the lack of wage growth is undercutting the pace of expansion and that they have overestimated end demand. We need to watch these developments because they could presage a pullback in the markets, especially if retail is weak through December and inventories are high next month. A slate of poor earnings and guidance and January will lead to a big round of layoffs, elevated jobless claims data and weakening consumer demand.

My view here is that this recovery is long in the tooth and that the risk-on trade has largely played out. The Fed’s tapering is a clear signal that this is so. We need to see this signal for what it is and react accordingly. Reaching for yield was the play while QE was running. But now, the winds are blowing in the opposite direction. Tapering means normalization and normalization means this cycle has peaked.

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