Tuesday, 24 September 2013

To taper or not to taper, that is the question!

The Federal Reserve surprised almost all of the market participants last week by deciding to maintain its current pace of asset purchases, at $85 billion per month, rather than "taper".  Having guided the market in May to believe, that it will commence its taper by reducing its bond buying program later in the year, its last week’s decision to carry on with its current bond buying program unchanged threw the markets into turmoil.

So what led to this dichotomy in expectations vs. reality?

Earlier in the year, in May 2013, Ben Bernanke guided the market that FED will commence to wind up the QE as and when the unemployment rate falls to 7 percent, with the expectation that that this might happen by mid-2014.  FOMC members repeated those details in speeches, some emphasizing "as early as September."

When the unemployment rate fell in August to 7.3 percent, not far from the threshold and with no caution from the Fed, the die was cast for “Septaper”, as far as markets were concerned.  As a result of the earlier guidance, the market interest rates started to rise in expectation of tighter money conditions with 10 year UST’s yield rising by almost 90bps over this period, in the process impacting economic activity, including home buying.

So when the FED announced on September 19, 2013 to keep its bond buying program unchanged, it caught market participants wrong footed and caused significant volatility in the global financial markets.  Asian equities, Emerging Market currencies and bonds rallied strongly while the UST’s and bonds bled with US equities recording a very modest change.

So, why did the FED decide to delay the taper?

To be fair to Bernanke, he did say that any decision to taper has to be backed by data confirming steady gains in the economy, in particular continued job growth and labour market strength.

Looking a bit deeper in to the data, there are 5 good reasons why the FED decided against the taper:

1.       Unemployment rate is misleading

The unemployment rate continued to fall, aided by reductions in the labour-force participation rate. As Mr Bernanke indicated last week, the Fed sees the unemployment rate as an incomplete measure of labour-market health. Guidance that QE3 would be complete roughly when the unemployment rate touches 7% seems no longer a good idea.

Fed has now declared that rates will stay low until unemployment is down to at least 6.5%, it may in fact leave rates low as unemployment falls well below that figure, so long as inflation remains in check. The current GDP growth rate of 2% is not strong enough for a sustained improvement in the labour market conditions.

2.       Payroll trends weakened during the summer

When Fed began to indicate its taper program the economy, was consistently adding jobs at a rate of about 200,000 per month. But subsequent reports revised down spring job gains and showed much weaker hiring over the summer. It has therefore reacted to the weakening job growth despite its earlier use of unemployment-rate thresholds as guideposts.

This has led many to argue that the Fed is losing its credibility. In my view, it’s far more important to do the right thing for the economy than being popular or pursue populist actions. Fed needs to be comfortable backing off guidance if it isn't likely to achieve its dual mandate. However, it’s communication of forward guidance to the market needs to get better.

3.       Inflation is trending below target

The FED Chairman considered that an inflation floor might be a useful thing to add to forward guidance. Depending on where the floor is set that could be an extraordinarily important development. The big failing of the forward guidance so far has been that it is entirely consistent with continued stagnation: saying rates will stay low until a particular unemployment threshold is met does not rule out stagnation, high unemployment, and low rates forever (e.g. Japan). An inflation floor, if set high enough, changes that by demanding additional action if the economy is not on pace to close the gap. A temporary inflation floor of around 2% would be a consistent with an intended normal growth rate for the economy.

4.       Fiscal cliff and Debt ceiling debates looming in the horizon

The Fed is rightfully worried that the "fiscal cliff" could seriously harm the American economy. Unfortunately politics is influencing monetary policy.  There is a strong possibility of a deadlock in debt ceiling negotiations potentially leading to government shutdown, Sequester causing deeper impact and a prolonged debt-ceiling discussion. The Fed has erred on the side of caution and has taken the approach of better-safe-than-sorry for now. 

5.       The Housing recovery has paused

Figures in 000s

The real estate sector has contributed close to 1/3rd of the GDP growth rate.  Recent data is indicating slowdown in housing activity as a result of the interest rate increases over the past few months. FED has an eye on the long term interest rates to ensure Mortgage interest rates do not spike up threatening the economic recovery.

The continued strength in the housing sector is critical for both labour market recovery and strong economic growth.

Is QE damaging?

The biggest argument made against QE when it started was that money-printing would necessarily lead to inflation. Surprisingly, that has not happened yet, and in any case, benefits of continuing the QE in for sustaining the economic growth is arguable.  However, the policy has painful side-effects, which is why the Fed wants to exit, albeit gradually with minimal market disruptions. Some of the unintended consequences of QE are:

Poor capital allocation and increased systemic risk

Lower rates, driven by QE, make it easier for inefficient companies to prolong its existence. This means that inefficient enterprises continue to receive credit resulting in poor capital allocation.  As the chase for higher yield spreads, risks to the financial system are increased manifold.

Asset price bubbles

Low interest rates will inevitably lead to asset price bubbles as buyers’ tend to take bigger mortgages driving the demand for housing further leading to the creation of conditions of next cycle of defaults as interest rates rise.

Currency volatility

QE has resulted in large scale capital flows into emerging economies resulting in significant credit expansion in some of these emerging markets.  The announcement of taper demonstrated its impact on some of these emerging economies causing significant currency and capital markets volatility.

Structural reforms take a back seat

QE also helps governments avoid necessary structural adjustments. Taper talk, starting in May, contributed to a sharp run on several emerging market currencies, with those of India, Turkey, Indonesia and Brazil prominent among them.

The market impact was focused on those countries that had fundamental problems, in the form of high current account and fiscal account deficits. This was not solely an issue of an indiscriminate shift in financial flows. The postponement of tapering raises the risk that adjustment will be painful when the end of QE finally comes.

Pensioners and savers suffer

By reducing bond yields, QE impacts the returns for pension funds. Any situation where many pension funds remain far short of meeting their commitments is undesirable. Senior citizens relying on fixed income from investment in bonds continue to suffer.  There has been a massive amount of wealth transfer from savers to borrowers resulting in perverse incentives.  The sooner the QE ends the better it is.


On balance, the FED’s decision to delay the taper at this point seems well founded.

However, improved forward guidance is desirable in order to avoid the gyrations in markets that resulted from the taper talk. The Fed did reckon that those gyrations and the rise in bond yields in particular, were damaging enough to warrant an action —through the choice not to taper.

The FED is rightfully focussed on achieving sustained labour market improvement as full employment will perk up wage growth, which is the kind of inflation the economy would do well with. A period of strong wage growth and higher labour participation rate will be the reassuring signs the Fed needs before allowing rates to rise.

As Bernanke hands over the mantle to the next FED Chairman in January 2014, it is highly unlikely that FED will make a move until Q1/2014 with its taper.  Even otherwise, the underlying data have to supportive for a move and the following factors will determine the timing the taper:

·         Unemployment rate to fall below 7%;
·         A rise in labour participation rate;
·         Inflation expectations above 2.5% p.a. driven by wage pressures;
·         GDP growth rate > 2.5% p.a.

So, in the final analysis, to taper or not to taper will depend on a combination of factors listed above and data is not likely to improve over the next few months on all fronts. 

The precise timing of the taper is a $42 question.  As 42 is the answer to the Ultimate Question of 'Life, the Universe, and Everything'!!!  [If you believe The Hitchhiker’s Guide to the Galaxy J].

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