Today we expect to hear the Federal Reserve’s decision on their monetary policy and the possibility of the “T” word (Taper). It’s sort of like Christmas for monetary and policy wonks as they wait for Bernanke to conclude the last meeting of the year and his last as chairman. The Taper Talk is reaching a crescendo and the probability that they will Taper by some amount is now above 50% among economists. The VIX is above 16 and the market is ready to move so the afternoon session could see some volatility, either up or down. Is the economy strong enough? This debate that has plagued economist’s forecasts as to what the Fed will do. However, as I have previously pointed out, there is some real math that must be taken into consideration.
There are two factors at play which will determine whether the Federal Reserve Tapers, if they maintain the status quo, or even if they ramp up their QE money printing / bond buying program. The primary factor is the economic data and economic recovery. This is what the media and economists continue to debate over. Is the economy growing fast enough, is it strong enough, what does the economic data tell us. For many, if not most of the political and ideological wonks out there, the economy and economic data is not just the primary factor, but the only factor in which the Federal Reserve will make any decision on QE, Taper, and monetary policy.
Dual Mandate, really?
The Federal Reserve has been charged with a “Dual Mandate” to contain inflation and also reduce unemployment to what they consider as their baseline. Truth be told, they have very little direct impact over either of their charged responsibilities.
Interest Rates and Inflation
They can lower and raise interest rates, which may or may not control inflation. In the 1970′s we saw how quickly inflation got out of control and how the Fed had to take radical measures to try to contain it, taking interest rates above 15%. Then, of course, we just had a massive economic crisis in which they took interest rates to zero and that didn’t stop the hemorrhaging, until they started printing money and DIRECTLY bailing out banks and financial institutions. So their interest rate tool has very limited ability to actually control inflation when they need to control it most.
Courtesy of Shadowstats.com
Their second charge of lowering unemployment and keeping it low is also a silly notion. The Federal Reserve has no control over fiscal policies and can’t draft legislation. So they are expected to use the same tool (and really the only tool), the control of fixed interest rates, to create jobs. Well, they took it to zero and it has been at zero for years now and the highly touted U3 unemployment rate has fallen to 7%, which would seem like something is working. However, there are several factors to take into consideration. First, the U3 rate is not a measure of TOTAL unemployment. We should actually look at the U6 rate which includes all those that are unemployed and that is running over 13%. Next, we must take into consideration the participation rate, which is at a 30 year low. Back out the drop in the participation rate and we are closer to 8% in the U3 number. I am still not certain and I don’t think anyone is able to clearly explain HOW the Federal Reserve actually LOWERED unemployment; they can’t, actually. Why they are charged with such a task is absurd and that responsibility should fall on Congress who controls taxes, legislation, and fiscal policies, all of which could be designed to incentivize business and citizens to seek jobs and for companies to hire, yet they do little in this regard. In fact, the U.S. central bank is the only central bank that is charged with unemployment, the rest of the world rightly thinks it is fairly idiotic to have a central bank be responsible for job creation and lowering unemployment.
Courtesy of Shadowstats.com
One can’t deny that for the academic economic and political wonks out there, all that economic data, theories, and debates make for some colorful conjecture, rhetoric, and commentary. But does it really mean anything? Much of the data contradicts each other and even more of it has become so muddy with methodologies and “seasonal adjustments” that I don’t think anyone has a clear idea what they are even measuring any more (read yesterday’s inflation report).
Do the Math!
For the first time in our history the Federal Reserve has vastly expanded their operations into controversial and radical territory. They are no longer a regulator and the arbitrator of interest rates who acts as a referee of the Free Market, they are now a participator. Their massive Quantitative Easing (QE) program amounts to printing trillions of dollars to purchase bonds and mortgages. The Fed has now become the vast majority, if not the sole buyer of all gross issuance, and is the ultimate market participator.
Our treasury bonds have not rallied and yields come crashing down because foreign nations, pension funds, and investors around the world believe it is a great investment. It rallied because the Fed has now become the net buyer of gross issuance. The same is true with Mortgage Back Securities (MBS). The Federal Reserve has replaced the traditional buyers of MBS risk and they are not stopping.
When you strip away the economic data and their dual mandate, the math is simple.
Government deficit spends X amount of dollars and needs to raise that by selling treasuries.
Interest rates are between zero to 3% (depending on maturity) and there are not enough investors to lend that X amount to the government.
Answer: Fed prints money to fund government deficit spending.
So while our media, economic, and political pundits pace the words, read the tea leaves, and point to economic data as to why the Fed made their decision, as if the economic data is the sole reason for making a decision, the MATH behind the curtain that no one wants to admit or discuss is the funding of both the treasuries and mortgages that have been needed to avoid inflation, dollar erosion, and mortgage debt collapse.
The crisis was not really adverted, it was just moved from the private sector to the public sector. The government, with the much needed help of the Federal Reserve, is trying to avoid the real crisis by printing money and buying time, all in hope that the REAL economy will recover enough.
As I pointed out before, there is some room on the balance sheet (MATH), for them to taper. This was created by the sequester, which reduced the budget deficit slightly, and also the increase in pay-roll taxes. However, the government is not really interested in reducing the deficit, the current budget deal ADDS over $60 billion per year in new spending with promises to pay in the future.
Currency War: Japan launched a massive money printing operation and thoughts are they will ramp it up again next year. Europe has continued their version of monetary easing as well. If the U.S. tapers while Europe and Japan does not it could create a bigger trade deficit.
Zero Interest Rates: It’s the chicken and egg problem. If interest rates remain low until the Fed’s target of 2016, then the demand for bonds remains very low. Weak demand in bonds means the Fed will have to continue to printing money and buy bonds. In order to attract bond buyers they need to raise interest rates.
Inflation: Part of the Fed’s Keynesian plan is to inflate their way out of debt. The theory is that if they can create some inflation, paying back debt with inflated dollars means they can pay it off faster on weaker buying power. Their current gauge of inflation is the CPI and with the proposal for adopting the C-CPI-U, the results would report a lower rate of inflation. With the CPI at 1.2%, the Fed may be concerned about deflation and feel the need to print more money and keep interest rates at zero for longer.
Will they and can they?
Can they taper? They have a little room on the balance sheet to do so. Yet they are still the net buyer of bonds and MBS’s, so they can’t completely, regardless of economic data.
Will they taper? Perhaps because the market and the world would like to see them stop printing and inflating the hidden inflation bubble, but only a little, because they really can’t.
Stuck or Addicted?
We are certainly stuck, but are we also addicted?
Fed doesn’t want to raise interest rates, thus making them the sole buyer of bonds.
Government doesn’t want to cut deficit spending, thus the Fed has to print money to keep the government flush with the cash it wants to spend.
The Western Nations are also trying to devalue and boost trade, thus the Fed can’t raise interest rates or tighten or they will curtail exports and the trade deficit will increase.
The Keynesian core theory is that spending grows the economy and savings stalls the economy. The QE policy and zero interest rates spur leveraged debt. The NYSE margin is hitting all-time highs (about to cross $500 billion), Freddie and Fannie are still operating under massive leverage, and the Fed doesn’t want to stop spending growth, thus they can’t raise rates or stop propping up the bond market.
QE is here to stay for the long run, in some form or fashion. It might get renamed (like Operation Twist), it might get some new window dressing, and it might be shaped into some new policy. Regardless, the math that drives QE is here and is not going to stop. There is no incentive to stop and therefore we are building a bubble bigger than the Dot.com and housing bubble combined.
Support & Resistance
INDU 15,600 – 16,000
The market will certainly rocket to the resistance or support and perhaps break through. It’s in the Fed’s hands now and how they are able to spin their monetary policy.
NDX 3450 – 3500
The tech heavy index has seen some volatility, but it is poised to also make a big move.
SPX 1770 – 1800
Will the SPX break out of support or resistance? Sure, today we could see a knee jerk move either way based on the Fed. The VIX is pricing in a move and is running in the 15+ range.
RUT 1100 – 1120
I continue to watch the broader based market to determine what the general order flow is. The RUT didn’t rally back like the other indices and that means there remains some trepidation.
If I had to place odds on any taper, it would be very small, perhaps 10:1. It would be window dressing at best and would be a gift for Bernanke to close out his legacy.
We know they can’t end it or taper a significant amount, so any taper is for show. Is it worth issuing a small taper now? I am not sure how the market will react, it may take it in stride or overreact. No one knows for sure. Expect some volatility.