The Taper Wars!
It was hard to be decisive on whether or not the Fed would taper. I was certainly on the fence and gave it a low probability, while the market gave it a 50/50 chance. No doubt there was some small room to taper (they tapered the bond purchases by $5 billion) and much of that is in line with the deficit reduction from the sequester and payroll tax hikes. They are currently purchasing 100% of all gross MBS issuance, and with interest rates up and a slight slow-down in new financing, there was most likely room as well. As I have been suspecting, Bernanke’s legacy does matter, he needed to end (or at least start to end) what he started. So it is time to review the Taper Wars.
The Taper Wars
What has transpired reads more like an espisode of the West Wing, or perhaps even Star Wars than actual reality, but sometimes the truth is stranger than fiction.
Courtesy of Tom’s MAD Blog
At the Federal Reserve a long, long time ago….
The Fed announcement that QE (so named before we started numbering them) was all that was needed and there was no plan for another. The problem was that government deficit was on the rise and, as interest rates continued to fall, the lack of demand meant that QE2 was coming. A short-time later QE2 was here. As before, it was limited in scope (money and time) and we were told it was all that was needed with no plans for another. A short-time later, as we saw a lack of demand in the long-dated maturities, the Fed again stepped in with “Operation Twist”, dubbed QE3. The word QE was becoming unpopular and the monetary policy was falling under criticism from our Western allies as the U.S. was devaluing and creating a trade imbalance. As before, Operation Twist was limited in scope.
Courtesy of deviantart
The problem with QE1, QE2, and Operation Twist was that they were limited in scope (time and money) and the hope was that the economy would strengthen, which would mean more revenue for the government, who would then dramatically reduce the deficit. The Fed faced a dilemma as the Federal Government’s fiscal policies did NOT align with the Federal Reserve’s monetary policy. In some respects the Federal Government became addicted to the free money the Federal Reserve was lending to them. Instead of reducing government spending, the government saw the QE program as an opportunity to expand spending. We quickly saw the largest ever ramp-up in government spending (and therefore deficit spending). For the first time since the 1970′s the government operated with no budget; they just expanded spending and pushed through continuing resolutions. This put the Federal Reserve in an awkward position. Even if the economic data improved, there was no way for them to stop their QE policy because the government became reliant on it for funding their deficit spending.
If you listened to the Congressional testimonies, Bernanke consistently told Congress they MUST control their spending, pass a budget, and create some limits. He warned that QE monetary policy could not go on indefinitely. In one infamous exchange, Senator Schummer pleaded with Bernanke to continue with the QE policy and stimulative efforts because Congress was incapable of doing anything.
This forced the Fed into their only option, an indefinite QE policy in which the scope of time and money was not defined. The Federal Reserve could no longer rely on the government to reduce their deficit spending to a level in which the Fed no longer had to supplement the bond purchases to fund the deficit spending.
The only other option was to raise interest rates to a level that would attract demand so the Fed could stop, but this wasn’t an option because it would directly impact the economy and perhaps stall it. Additionally, many economists believed that the government couldn’t afford higher interest rates at its current debt and deficit spending levels.
QE3 had little to do with unemployment rates and inflation, and everything to do with funding government deficit spending.
There were two small and hopeful surprises for the Federal Reserve in 2013 as it related to their endless undefined QE 3 program. The Sequester and the Payroll Tax hike helped to reduce the deficit and, therefore, helped to reduce the funding requirement by the Federal Reserve’s QE3 program.
The problem at this point was that after the market had embraced the endless QE3 program, how could they turn it off? It seemed that QE was here to stay and everyone, not just the government, became addicted.
Obama Strikes Back!
Courtesy of jocosob.net
There was also the Bernanke Factor. He had already made vocal his criticism of Congress’s inability to reduce deficit spending. He was also the one that saw the opportunity with the Payroll Tax Hike and Sequester to reduce their QE money printing and asset purchasing program. Rumors have it there exists some animosity towards Bernanke from both Democrats and the Administration. He warned them and was now possibly threatening to turn off the spigot of free money that was funding the government’s deficit spending. The Administration and Democrats became reliant on the Fed’s money and with Obamacare and talks of additional stimulative efforts, they needed the money for their programs.
Bernanke’s public address about the possibility of a Taper in late spring 2013 sent ripples and concerns throughout the market. Additionally, we saw the Administration move against Bernanke and planned on replacing him when his term was up. President Obama even slighted Bernanke in an interview about the ending of his term and clearly stated Bernanke was not even considered for another term. For political and economic wonks, it amounted to pretty much saying, “Bernanke is done! He threatened to Taper and he is gone when his term is up. We will find someone that will toe the party line!” Rumors have it that Bernanke has been shunned from White House gatherings.
Yellen was the obvious pick. She is pro-stimulative, pro QE, a staunch Keynesian, and has even voiced her support for increased government social and entitlement programs. She was a perfect fit and would certainly NOT turn off the money or be critical of government deficit spending. If the government was going to deficit spend with zero interest rates, it needed an ally in the Fed; Janet Yellen was that perfect ally.
Revenge of the Bernanki
Courtesy of the Atlantic
So what next? Bernanke is still in charge and there is, of course, his legacy. I believe that after years of QE, his vocal criticism of Congress’s inability to manage deficit spending and debt, he became acutely aware of the addiction he had created. While I believe he is still very much a Keynesian, he is also a pragmatist, to some extent. Whether or not he believes QE worked and was successful, the Federal government has become addicted to the money and has not been responsible in their actions to reduce the debt and deficit spending. Bernanke’s only action is to taper!
If we look at the math, there was room to taper; it was now or never. Perhaps this is Bernanke’s last warning shot across the bow of the Administration to warn them not to rely on free money and to get their fiscal house in order. It certainly marks his departure and is an attempt to end the QE program he started (hopefully with the perception of a mark of success of the QE program for future history books written about the recovery).
The fact is, the ability to taper will continue to be handcuffed to the government’s need to fund their deficit spending.
The taper won’t end until either:
1. Government’s deficit spending is reduced 80-90%, in which the Fed no long has to participate. Deficit spending reduction can happen in any combination of three ways:
a. Government cuts spending.
b. Government raises taxes.
c. The economy improves in which the existing tax structure generates more income for the government.
Note: it is option C that the Federal Reserve and government are betting on.
2. Federal Reserve raises interest rates enough to create a demand for government bonds. However, this option could stall economic spending growth and will add further debt to the government, which it can’t afford.
That means the only realistic option is government deficit spending is reduced a significant amount. If the government continues to do nothing (with fiscal policies) and HOPE for CHANGE, in which the economy improves enough to reduce deficit, it will mean a very slow taper – perhaps years.
The addiction remains an additional problem. If you have a government that wants to expand social and entitlement programs, wants to stimulate, wants to create “shovel ready programs”, want to spend more – well the only option is QE.
Frankly, their “dual mandate” of unemployment and inflation is a side show, window dressing, a diversion to the real math. It makes for important economic data for politicians and their election process. It certainly makes for great academic debate and commentary. At the end of the day, however, it is not the real math driving the decisions of QE and monetary policy. Cut through the fluff and rhetoric and do the math.
Support & Resistance
The market rocketed higher and strongly broke through the 16,000 level. However, was this strong rally just a knee jerk move? I would be skeptical of 16,000 as a support level if we pull back down.
The NDX was under pressure yesterday before the Fed decision, but managed to get up to the 3,500. Is this a resistance level?
We got right there and now what? It is certainly a resistance level and fear has left the market as the VIX has fallen from 16 to 13 and could go lower. Is there still room for a Santa Claus rally?
The broadest based index still didn’t even get to the previous 1145 high. He made a good move higher, but stalled short of 1140. I think the market is getting a little frothy and any Santa Claus rally from here until the New Year is going to be hard pressed. Be thankful for what you got, cash in your chips and go spend time with the family and friends.
Attack of the Clowns!
The Taper and Bernanke story has come to an end. There is a new chapter in the QE book, the Yellen chapter. It is not yet written, but we may know the prologue. Only time will tell. I believe we will see a much more dovish stance in the Federal Reserve. Perhaps, like Bernanke before her, she will be naive and believe in the Keynesian way. Perhaps she trusts too much in the government U3, CPI, and data to justify her positions. She has also not yet faced the constant incompetence of Congress and their inability to manage a check book, balance a budget or even create a budget. Maybe before it is too late, she will see the light and no longer be blinded by her ideology and theoretical beliefs. Unfortunately, it took Bernanke years before he saw the light; we don’t have years for Yellen to become a pragmatist.