By Jason Van Steenwyk
The next two days may well mark a decision point for the Federal Reserve’s Open Market Committee. Right now the Fed has the Quantitative Easing tiger by the ears: It can’t hang on forever – but it knows that letting go is fraught with some problems of its own as well.
The hawks on the FOMC – and most folks who are long the USD and in dollar-denominated assets, would like to see the Fed begin that long-anticipated ‘tapering.’ That is, they’d like to see the Fed gradually pull back the throttle on purchasing $85 billion worth of mortgaged-backed securities every month, and they’d like to see it as soon as possible.
It’s getting increasingly likely that that’s going to happen sooner, rather than later. The Federal Reserve has been slow to ease up on the throttle, citing a fragile economy and meager economic growth. But there are some economic indicators coming out recently that could give the inflation hawks some ammunition. Specifically, an encouraging Employment Situation Report (by today’s standards, anyway!), a housing market that’s heating up, a strong November Retail Sales Report, and just this week, the announcement of a tentative budget deal in Congress that would forestall a shutdown over the debt ceiling in February.
The news isn’t all rosy, though. The doves on the FOMC have some ammunition of their own. For example, the labor force participation rate – that is, the percentage of the adult population actually working, is the lowest it’s been since 1978.
Furthermore, ongoing uncertainty from the Affordable Care Act – and its disastrously inept implementation – is putting downward pressure on hiring. The ratio of part-time to full-time workers has skyrocketed over the last year, compared to historical levels, as employers scale back hours to bring them under the 30 hour threshold, over which the employer mandate (now delayed until 2015) kicks in and companies with over 50 full time equivalents must provide a group plan for these employees or pay a stiff penalty.
Both of these factors have significantly restricted the employment picture – especially among lower-skill employees, for whom the cost health insurance is a large fraction of the the value they can contribute to the employer. From the point of view of the ordinary worker, America needs as much job creation and economic opportunity as it can get, inflation or no.
A Quick Primer on Open Market Committee Operations
So everyone understands: The way the Federal Reserve controls the money supply is largely by what is called “open market operations.” When it wants to rev the economic engines, the Fed will buy bonds – historically treasury bonds, but the latest round of quantitative easing, QE3, was a massive push to buy mortgaged back securities.
When the Fed buys bonds over the open market, it pays cash. Or, more precisely, it credits the reserve accounts of its member banks with cash – against which these banks can lend money. The greater their reserves, the more money they can lend. The supply of money available to lend goes up, of course, and as supply increases, the price of money tends to decrease. Hence, the Fed pushes interest rates down and increases the amount of liquidity floating around the economy. More people can borrow more cheaply, consumption increases, productivity increases, and economic activity increases, we hope, across the board.
However, if the Fed overdoes the bond buying, the lending gets out of control, and we wind up with too many dollars sloshing around the economy, chasing too few goods. The value of the dollar begins to fall, and we have inflation.
To counter inflation, the Federal Reserve Open Market Committee sells bonds back to the market: This process sops up the excess cash, which the Fed then takes out of circulation. The money essentially disappears. It was created by fiat, and therefore disappears by fiat. However, we haven’t seen a major Fed tightening cycle since 2004-2006.
Until last week, most observers expected the Federal Reserve to begin the tapering process in mid 2014 or later. But last week’s Employment Situation Report may have given the inflation hawks the ammunition they need to pull the trigger much sooner than they had hinted.
The Bureau of Labor Statistics announced that the economy had created 203,000 jobs last month… enough to push the unemployment rate down from 7.3 percent to 7.0 percent.
What is the likely effect of a taper?
- Well, it would represent a gradual decrease in the rate of increase of the money supply. This is a very different thing than an outright cut in the money supply, which is what will happen when the Fed becomes a net seller of bonds. The word “tapering” means the Fed plans simply to buy fewer bonds going forward than it did before. However, the net result of a fed tapering will still be expansionary to the money supply for some time.
- Less support for the housing industry. The fact that the Fed is a ready buyer of $85 billion in mortgages per month is a godsend for Fannie and Freddie. The hope is that Fannie and Freddie, etc. al., won’t need that crutch anymore.
- Upward pressure on interest rates, as borrowers compete to borrow fewer available dollars for lending… especially in the mortgage space, but since money is fungible, these effects quickly spread throughout the economy.
- Support for the dollar against other currencies, as a signal to taper early could be viewed by the markets as a sign that inflation hawks have the upper hand against doves pursuing growth at the cost of inflation.
The market effects of a taper are much more difficult to predict. If the Fed does actually begin a tapering policy, will that convince the bond markets that the Fed is, in fact, vigilant against inflation? The incoming presumptive Fed Chair, Nancy Yellen, has a reputation for being dovish on inflation. That is, the expectation seems to be that she is willing to accept inflation in exchange for continued economic expansion and lower unemployment.
That works out great for labor and exporters, who benefit from a weak dollar that makes American exports more affordable. It’s not so great for people who hold dollars, or any financial asset denominated in dollars. The short version: That’s bad news for lenders.
In the short term, dollar holders seem to like the news that the Fed will begin to taper. It will be a welcome sign for those long on the dollar that the era of cheap money is coming to an end. Long-term lenders won’t have to bid up long-term interest rates to compensate for inflation, which will at least put some downward pressure on mortgage rates, but a reduced money supply eventually translates to higher interest rates on shorter-term debt, because borrowers must compete more intensely for every dollar of available credit.
With a taper increasingly likely, dollar bulls have been bidding it up. Nevertheless, the inflation doves have their own case to make, too: The Labor Force Participation Rate was at a 34 year low as recently as November. Behold the graph posted above. Note that any increase in it in December would have to be adjusted for seasonality (and returning furloughed federal employees!).
Furthermore, the dismal performance of Treasury Inflation-Protected Securities (TIPS) over the last few weeks has been signaling that bondholders actually fear a possible deflationary cycle. If we begin winding down QE3 now, that could serve to push the economy from a stagnant price inflation environment into a deflationary spiral. If business believe prices will decline, they will put off making investments.
Will the Fed jump the gun and begin tapering this month, well ahead of the expected March commencement date? We’ll know this week: The next Federal Open Market Committee Meeting occurs on December 17th and 18th.
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