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%. Manufacturing looks to be reviving, budget negotiations are less toxic and the global backdrop is supportive. Only inflation — at 0.7% 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%, 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.”
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 805 of the debt the U.S. 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 mispricings, 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.
— James Saft. Saft is a Reuters columnist.