Forget Tapering, and Get Ready For QE4
Markets have been excessively spooked by the prospect of Fed "tapering" (reducing bond purchases). Rates on long-term treasuries have risen by 100 basis points since hints, first voiced by Chairman Bernanke at his May 22 JEC testimony, that if economic performance holds steady (growth above two percent and unemployment falling) or improves and inflation remains low (it is actually falling, to a one percent or lower pace), the Fed could start reducing the pace of its bond purchases (QE), by year-end. It is more likely, in view of the negative impact on the already weak U.S. economy arising from the higher interest rates resulting from taper talk, that the Fed will have to reverse itself (again) and start talking about "un-tapering" or QE4 at its December meeting.
The Tapering Trauma
Since May, many in markets have convinced themselves that the Fed will actually start tapering at its September meeting. Most are calling for modest unwind that reduces the Fed's monthly bond purchases by about $20 billion, from $85 billion to $65 billion per month. As noted already, and perspective homebuyers know well, fears of this and further tapering have also boosted mortgage rates by a full percentage point, from about 3.5 percent to 4.5 percent. That jump creates a big reduction in housing affordability, at least an extra $200 per month on a $240,000 mortgage.
Higher mortgage rates have spooked both homebuilders and home buyers. June housing starts plunged by over 9 percent month-over-month while building permits, often a forerunner of housing starts, fell in June by nearly 8 percent month-over-month. July saw only partial reversals of June's very weak data, and July new home sales plunged by 13.4 percent month-over-month, the largest drop in more than three years.
Tapering Down the Taper
There are three reasons to expect reversal of the higher interest rates and the taper talk that have emerged since May. First, the supply of treasuries coming to markets (government borrowing needs), by virtue of a sharp reduction in the heretofore $1 trillion budget deficit, drives down interest rates. The deficit has been reduced by about $400 billion, due in large part to tax increases enacted in January 2013 and spending cuts that are continuing to result from the March 2013 sequester. Ongoing deficit reduction will reduce treasury borrowing needs even further in coming years by an average of $400-500 billion per year relative to 2012 levels. If, for example, the Fed cuts QE bond purchases by $20 billion per month in September, as some have suggested, there is an actual reduction in the supply of bonds for markets to absorb in the 2014 fiscal year that begins on October 1, 2013. Given the sharp drop in deficits, the Fed can cut bond purchases by about $40 billion per month - $480 billion per year - and leave the net supply unaffected based on post-2012 deficit reduction.
Another reason for the reversal in "taper trauma" interest rate increases is the slowing of the U.S. economy that is currently underway. Forecasts of third quarter growth (the official figure will be released on October 30, 2013) have softened from about 2.5 percent in early August to 1.5 percent in early September, perilously close to a one percent stall speed. The slowdown is a natural result of early 2013 tax increases and from spending cuts tied to the sequester that imparted a 2013 "fiscal drag" equal to about 2 percentage points of GDP growth. Slower growth means less borrowing by households and firms and lower interest rates.
The economic slowdown that is frightening the Fed, along with numerous U.S. households and businesses, produces a policy feedback effect that is also supportive of lower interest rates. Slower growth has pushed the Fed to temper its recent taper talk. Sustained QE at $85 billion per month, to be announced after its September 17-18 meeting, is becoming more likely as the Fed is pushed to return to full support of the slowing economy by employing sustained QE.
A third reason for interest rates to fall back toward April's record low levels, and perhaps, for QE to rise back-to-or-above April's record high is tied to a persistent drop in inflation that has appeared since mid-2011. The core personal consumption expenditures (PCE) price index stayed at 1.2 percent in July, well below the 2 percent Fed guideline (see figure 1). Lower inflation lowers expected inflation and thereby reduces market interest rates. Also, lower inflation pushes the Fed towards more QE. QE2 resulted from a mid-2010 "deflation scare" which Chairman Bernanke cited during his August 2010 Jackson Hole conference speech.
The Fed's mandate includes, along with a commitment to "full employment" (an unemployment rate of around 5-5.5 percent, well below today's 7.4 percent), a commitment to low and stable inflation of about 2 percent. Actual inflation is currently closer to 1 percent, and by that criteria, as well as the "full employment" criterion, the Fed should be increasing its underlying QE, not tapering it.
Look for taper talk to continue withering, a trend reinforced by Chairman Bernanke during his semi-annual July 17-18 Humphrey Hawkins testimony to the Congress. Further, Bernanke has indicated that if growth slows sharply and-or deflation threatens, he would urge the FOMC to consider raising QE to $100 billion per month. That, of course, would push interest rates back-to-or-below two percent for 10 year bonds and three percent for 30 year bonds.
What Caused the Taper Talk?
In view of the Fed's oft repeated full employment, low inflation mandate, it is reasonable to ask: why, given slowing growth and falling inflation, did Chairman Bernanke choose, on May 22 during his congressional testimony, to initiate the "taper talk" in the first place? Nobody knows, but there are probably three reasons. First, the economic outlook, as already noted, was better during April in May, when the "taper" suggestion was being shaped at the Fed. Third quarter growth was then expected to be 2.5 percent or higher and the Fed, along with many private sector forecasters, was predicting 2.5-3 percent growth during the second half of 2013 and even more robust growth in 2014. Also, the lower inflation pace was dismissed by the Fed as "temporary." Overall, the Fed cast taper talk in terms of its own rosy forecast, which has since looked much too optimistic.
The second reason for openly considering less QE is related to the need for harmony on the FOMC as the Fed navigates uncharted waters in its conduct of post-financial crisis monetary policy. QE has grown increasingly controversial among FOMC members. The June and July meetings took no action to alter QE while discussing the possibility of doing so in future meetings, probably in September or later. Chairman Bernanke may have decided by May that rising FOMC discord over QE was counterproductive and so hoped he could move away from it without spooking markets.
As it turned out, markets were spooked by taper talk. Interest rates and uncertainty rose with both changes harming growth as households cut consumption (except to autos which really constitute household investment in capital) and businesses cut investment. As a result, demand growth has weakened, inflation has slowed, and taper talk has begun to be undercut by its negative impact on the economy and the continued very low levels of inflation. To have said nothing -- awaiting a time when tapering was clearly justified by the economic conditions -- would, with the benefit of hindsight, have been better. Taper talk has somewhat ironically made taper action less likely.
Finally, a cost-benefit analysis may have pushed Chairman Bernanke to hint at abandoning or reducing QE. Evidence that QE3 has been effective as a means to boost the economy is absent at worst and weak-to-anecdotal at best. It is very difficult to conduct empirical tests of the effectiveness of QE. The sample period is short and model specification is difficult, especially in the aftermath of the Great Recession and the turmoil of the 2007-2008 financial crisis. Bernanke may have reasoned that if QE isn't doing much to help the economy, while showing counterproductive dissention within the ranks of the FOMC, why not abandon it?
Taper Talk Will Change to QE4 Talk
Abandoning QE may be a good idea eventually, but it is not a good idea now while fiscal policy is tightening, U.S. and global growth is falling, and inflation is falling as well.
Investors show few signs of betting on higher inflation. Recent data has shown that investors -- abandoning their bond holdings as rates rise (and prices of bonds fall) on QE tapering concerns during June -- withdrew $43 billion from taxable-bond mutual funds alone. A large portion of the funds being withdrawn from bond investments is flowing into cash and money market funds rather than into stocks. That flow reflects investor concerns about slowing growth and possible deflation, both developments that would favor cash over stocks while creating an incentive to move back into bonds.
Taper talk will end soon, displaced by talk of QE4. We've had two false starts toward Fed tightening since 2009. Now taper talk has given us a third.