Fed finger on the taper trigger

August's jobs print is the only new consideration between now and mid-September as the Fed makes its next decision on quantitative easing. And investors are getting nervous.

The growing use of the word ‘tapering’ in economic circles is the reason stocks and bonds reacted the way they have overnight.

On Wall Street, the S&P 500 index fell almost 1.5 per cent as investors fretted that the word is about to become more than just talk, while the 10-year US bond rose around 7 basis points.

The term found its way into the economic lexicon in May when US Federal chairman Ben Bernanke stated in testimony before Congress that the Fed may ‘taper’, or ease, its program of bond-buying, known by the less-sexy term ‘quantitative easing’.

Currently the Fed is purchasing $US85 billion of US Treasuries and mortgage debt each month in an effort to put downward pressure on interest rates – and it has been working.  It has allowed bond markets and stocks to perform at higher levels than they would otherwise.

The Fed’s plan to kickstart stalled economic growth and create jobs in America since the 2008 financial collapse has been largely through its three quantitative easing programs.

The theory goes that if the Fed prints money to buy bonds then it provides the global financial system with fresh money to spend.

Increased spending raises prices and increases confidence for consumers to, in turn, start spending again. Once spending and confidence comes back, economic growth follows and, voila, you have job creation.

But like stacking up dominos, each factor in the plan relies on the one before it falling just right to have that knock-on effect and get right to the end.

Ben Bernanke says he will only pull the trigger on tapering and start removing the Fed from the bond market if incoming data suggests the economy is continuing to improve and ready to hold its own.

The main economic dominos he is looking at include the unemployment rate, the growth rate, consumer confidence, housing and inflation.

US Labor Department figures released last week showed US unemployment is continuing to fall, the headline rate is down from 7.6 per cent in June to 7.4 per cent in July.  Let’s remember that it was only as recently as 2009 that US unemployment stood at 10 per cent.

Growth is also up, albeit sluggish and in no quick hurry.

The US economy grew from April through June at a modest seasonally adjusted annual rate of 1.7 per cent. While that is not so impressive, it is up from 1.1 per cent in the January to March quarter and much higher than was expected.

Recent retail sales figures were also up for a fourth straight month, showing that people are spending again. 

Home construction grew 13.4 per cent in the three months to June, assisted by Fed-suppressed interest rates, and in line with the previous quarter.

The only troublesome domino is inflation.

It is coming in at well under the Fed’s 2 per cent target. That is a worry because low inflation encourages businesses and consumers to put off purchases, which undermines the Fed’s efforts to keep interest rates so low.  Why lower borrowing costs for consumers if it isn’t encouraging them to spend.

But four out of five ain’t bad, right?

Those economic green shoots have prompted the Federal Reserve Bank presidents of Dallas, Atlanta, Cleveland and Chicago to suggest that tapering may start as early as September. If anyone should know what will happen these are the people, some of them will be voting on what the Fed ultimately decides.

"There is no such thing as QE infinity. There are limits to how much we can put on our balance sheet. And there's also limits to the efficacy, the effectiveness, of what we do," Dallas president Richard Fisher said last week.

Bernanke has been laying the ground on this move for months but he is clearly nervous about the effect on the economy when the Fed starts pulling back on its bond purchases.

“A premature tightening of monetary policy (i.e. tapering or quantitative easing) could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further,” he said in May. “I want to be very clear that a step to reduce the flow of purchases would not be an automatic, mechanistic process of ending the program. Rather, any change in the flow of purchases would depend on the incoming data and our assessment of how the labour market and inflation are evolving.”

Bernanke is getting ready to hold his breath because his strategy to prop up the bond and stock markets has created a bubble.  The market doesn’t quite know the real value of whatever it is trading, except that it has to be lower than the price it has been inflated to.

The fear is that if the Fed tapers back its stimulus then bond and stock markets will perform more in line with fundamentals, which have not been crash hot.  But propping up the market was never intended to be a long-term thing for the Fed.

Investors are starting to price in the estimated effect of the Fed tapering its bond buying program sooner rather than later.  That is the reason for the movement this week in both those markets.

The release of the jobs report for August on September 6 will be the last data point that the Fed will look to before its meeting on the 17th and 18th.  If that shows unemployment has dropped further, then expect the Fed pull the tapering trigger.

Bernanke will be hoping he has read the signs correctly and that the dominos he has long laid out will fall as he wants them to, otherwise he will be spending a long time stacking them back up.

Mathew Murphy is a Walkley Award winning journalist based in New York.

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