To taper off or not to taper off
It has been a couple of weeks since the phrasal verb “to taper off” became the latest market buzzword. Every US economic release and verbal intervention by a US Federal Reserve member are now assessed by this yardstick. When will the Fed reduce its asset buying program purchases, the famous third round of quantitative easing (QE3), currently at USD 85bn a month (40bn for mortgage backed securities (MBS) and 45bn for Treasuries)?
The “taper off” frenzy has led to bizarre market reactions. While one might think that better-than-expected economic activity indicators would boost investors’ morale and worse-than-expected ones dampen it, several releases triggered the opposite effect. Market participants see good economic numbers as increasing, and weaker releases decreasing, the likelihood of an early Fed exit.
Their paradoxical reactions show that, for the time being, they remain unsure about the strength and persistence of the ongoing recovery. If the Fed withdraws the punch bowl too soon, wouldn’t there be a risk of “japanification”? Meaning, wouldn’t the US slip into an inescapable deflationary stagnation as Japan did in the 1990s? Or even worse, couldn’t we see a plunge back into recession as we did in 1937 during the Great Depression?
Those fears might be justified, but we should also acknowledge that the Fed cannot continue its QE program forever. QE certainly provides benefits in the form of cheap liquidity, a cushion against deflation and a welcome helping hand from the central bank to the political sphere in not letting public debt run amok. But it also has costs. We can lists four major ones: it stokes financial imbalances, disrupts agency MBS and Treasury markets, can result in bond holding losses when it ends, and threatens an inflation spiral due to unhinged inflation expectations.
Financial imbalances can arise because maintaining an ultra expansive monetary policy for a prolonged period can produce bubbles as investors “reach for yield” in an ultra-low interest rate environment. Some credit indicators are already pointing to stretched markets. The share of high yield bond issuance has returned to historically average levels, and high yield credit spreads have compressed noticeably, although they remain above their pre-crisis lows.
Fed purchases of outstanding agency MBS and Treasuries can interfere with, even disrupt, the proper functioning of these markets. A survey conducted by the New York Fed showed that eight out of 21 primary dealers noted a worsening of agency MBS market functioning since QE3 started.
Wall Street Journal author Andy Kessler made a similar case for the Treasury market, stressing “the distortion the Fed policy has inflicted on […] repurchase agreements.”
If the Fed decides to sell its bond holdings when it exits QE, it could incur massive losses on its balance sheet by selling into a market of rising rates. Its earnings could turn into losses for a few years, which in turn could jeopardize its independence if Congress deems them unacceptable.
Finally, and this is what many gold bugs fear, QE carried out too long can increase inflation expectations, with all the consequences this shift can have on actual inflation. However, this concern is currently the least pressing because inflation expectations remain well anchored, while actual inflation has fallen in the last six months, leading to renewed fears of deflation.
All in all, we should prepare ourselves for an impermanent QE. The Fed’s cost-benefit analysis will decide the timing of the tapering off. While we expect an only somewhat better economic outlook for 2014, the QE3 costs are mounting with each Fed bond purchase, and we expect the tapering off to start at year end. Let’s hope the announcement is seen as a sign of economic healing and not deemed premature by investors.