Opinion

James Saft

Fed may wait, you shouldn’t: James Saft

December 17, 2013

Dec 17 (Reuters) – The Federal Reserve probably won’t taper
when it meets this week, though maybe it should.

Financial markets definitely ought to sell off no matter
what the Fed does, but almost certainly they won’t.

The Federal Reserve will announce its interest rate policy
on Wednesday, after which Ben Bernanke will get a chance to
explain why, or why not, they choose to reduce bond purchases.
While less than a fifth of economists polled by Reuters expect
the Fed to taper in December, a recent run of encouraging data
has driven that figure up four-fold in just one month.

By Bernanke’s own three-part test – jobs, economic growth
and inflation – things are not that bad. Employers took on
203,000 extra workers in November, in what is looking like a
trend, and unemployment fell to 7 percent. Manufacturing looks
to be reviving, budget negotiations are less toxic and the
global backdrop is supportive. Only inflation – at 0.7 percent
in October – remains stubbornly below-target.

Indeed from a risk management standpoint, continued bond
buying may carry more potential risks than putative benefits.
On the positive side, quantitative easing had made financing
cheaper, supporting the prices of everything from houses to cars
to art to stocks and bonds. That has helped to repair household
finances, at least for those lucky enough to have wealth and
borrowings in the first place.

It has done this, though, while redistributing wealth
generally upward and toward those involved in financial
intermediation.

A look at what those borrowing cheap money are doing with it
also provides ammunition for arguing for a taper. Corporations
have added more than $800 billion of credit market debt to their
balance sheets in the past year, taking growth in the credit
market to 9 percent, nearly three times growth in the economy.

Yet, corporations are not re-tooling and expanding. Instead
they are simply engaging in financial engineering by buying back
more than $360 billion of their own equity. That flatters
earnings and seems to drive stocks higher, but does nothing to
improve the productive capacity or competitiveness of the
economy.

“Clearly not all debt is bad, but when it is spent
un-productively, then you start to worry,” David Rosenberg,
economist at Gluskin Sheff, wrote in a note to clients.
“If the money had gone toward productive investment, then it’s a
non-issue really. But as best I can tell it hasn’t – the capital
stock keeps getting older; the infrastructure keeps getting
older.”

CORNERING THE MARKET

Perhaps the best argument for a taper is not so much
economic as practical: the Fed is running out of bonds to buy.
December purchases of Treasuries, including reinvestment of
maturing bonds already owned, is equal to more than 80 percent
of the debt the United States issued in November. There is a
fine line, perhaps already passed, between distorting incentives
to achieve a given outcome and setting yourself up for a fall
when you stop.

The worry is that by distorting the market, you’ve created
mis-pricings, often called bubbles, which will have a
destructive impact when they pop.

So while inflation and the transition from the Bernanke era
to Janet Yellen’s leadership early next year are all good
reasons to wait, the other side of the equation perhaps has more
heft.

Now if the Fed, as is likely, delays the inevitable and
doesn’t taper, we can almost certainly expect a handsome holiday
rally into the New Year. Investors are positive already; they
mistake their paper gains for genuine growth in the real
economy, and quite frankly, many believe the Fed wants them to
make money and will tailor policy accordingly.

That rally would be a huge mistake.

A taper is inevitable, and with it, years of delayed costs
will come due. Interest rates are going to rise, and the one-way
bet called the bond market will become exceedingly unpopular.
That will hurt equities ultimately but knock over a fair few
dominos on the way. The housing market in hot areas is already
starting to buckle, with Southern California joining boom areas
like Phoenix and Las Vegas in having double-digit falls in
sales.

Credit markets will also quickly cool, saddling investors
with paper losses, potentially leaving households and businesses
dependent on a banking sector that may not prove up to the task.

All of this is going to happen at some point. For the Fed -
and for investors – the main issue is finessing the timing.
The Fed may wish to wait, hoping the economy is better able to
stand the strain next year.

If so, and if investors raise their bids for risky assets
like stocks, you just might want to oblige them by selling.

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