A Word on the Non-Taper

As you all know by now, last Wednesday the Federal Reserve policy decision was released, and to the surprise of many investors and economist, there was no taper. The decision was a surprise based on the fact that the Federal Reserve had signaled in May that a reduction in the rate of asset purchases was imminent, although it also stressed that the decision would be data dependent. Ben Bernanke outlined the reason for the non-taper in his statement, saying:

But in evaluating whether a modest reduction in the pace of asset purchases would be appropriate at this meeting, however, the Committee concluded that the economic data do not yet provide sufficient confirmation of its baseline outlook to warrant such a reduction. Moreover, the Committee has some concern that the rapid tightening of financial conditions in recent months could have the effect of slowing growth, as I noted earlier, a concern that would be exacerbated if conditions tightened further. Finally, the extent of the effects of restrictive fiscal policies remains unclear, and upcoming fiscal debates may involve additional risks to financial markets and to the broader economy. In light of these uncertainties, the Committee decided to await more evidence that the recovery’s progress will be sustained before adjusting the pace of asset purchases.

In other words, there was a three pronged rationale for not tapering:

Insufficient confirmation by the data – even though the employment rate has fallen over the last few months, the fall hasn’t been for the right reasons. Bernanke, in the Q&A session elaborated on this, saying:

…the unemployment rate is not necessarily a great measure in all circumstances of the–of the state of the labor market overall. For example, just last month, the decline in unemployment rate came about more than entirely because declining participation, not because of increased jobs. So, what we will be looking at is the overall labor market situation, including the unemployment rate, but including other factors as well. But in particular, there is not any magic number that we are shooting for. We’re looking for overall improvement in the labor market

In addition to this, inflation being below the target area of the Fed meant that a tapering wasn’t necessarily warranted.

Rapid Tightening of Financial Conditions – The tapering seed was planted at Ben Bernanke’s May 22 congressional hearing. Since then interest rates have risen, and in particular mortgage rates:

Given that the housing recovery is one of the driving factors behind the economic recovery as a whole, the continuation of the above trend would be problematic to say the least.

Fiscal Uncertainty – With another battle over government finances looming, to withdraw the pace of bond buying now would look to be imprudent, with the worry being that tightening monetary policy just as fiscal policy is tightening would be far too much for an already weak economy to handle.

Much of the reaction to the non-taper was that of surprise, in a negative sense, owing to the ‘communications problem‘ the Federal Reserve has created. That line of thinking suggests because the Federal Reserve hinted at tapering, conditioning the market to act in a certain way, the failure for the Fed to follow through creates unnecessary volatility and uncertainty in the market. This line of thinking misses two, related points. The first is that the Federal Reserve had always maintained that its actions were data dependent. Furthermore, should that data (which the Federal Reserve hopes to improve by maintaining its policy) get to a point at which it does confirm the outlook and allow for tapering, that very tapering will then jeopardize the performance of the data points going forward.

Said differently, the improvement in the economy, based on the continued easy monetary conditions, will be reversed if those easy monetary conditions are removed. In my view, the reaction to the non-taper displays a fundamental misunderstanding of this point, which was the subject of my last post. The vast majority of the investment community and mainstream economists are of the belief that, while necessary in 2008 to stave off a depression, was just that – a necessary emergency measure. Five years later, with the stock market at all-time highs and home prices off the bottom, we are no longer in an emergency state, and thus stimulus can be withdrawn.

Not tapering is worrying to this camp because it means that either the economy is much weaker than was anticipated, or that the Fed is overstaying its welcome with stimulus and sowing the seeds of greater problems in the future via inflation down the road. The sobering reality is that both points are actually true, and in the wake of the taper it seems as though the mainstream is slowly, but surely getting the point. Take Joe Kernan on Squawk Box this morning:

I didn’t know the economy ran on a gas that is QE

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