Time to end the taper caper

A former US Fed official has suggested a policy prescription that will horrify markets. He suggests the incoming Fed Chair should immediately start unwinding quantitative easing and decisively wean markets off their addiction to liquidity. Not that it would matter to ordinary citizens because, according to this former board member, QE has had little impact anyway.

The sub-par recovery in the US is proof that the direct effect of quantitative easing has been minimal said Dr. William Poole, former president of the Federal Reserve Bank of St. Louis, at a CFA Institute investment conference.

Markets certainly give the impression that the third round of quantitative easing has had the desired impact – asset prices are up and long term bond yields have been suppressed at artificially low levels – but Poole believes it is the concept of quantitative easing, rather than the actual $85 billion in monthly asset purchases that is driving the market.

It is a vastly different view to explain the rationale behind the spike in 10-year Treasury yields in May of this year when tapering QE was first mentioned by current Federal Reserve chairman, Ben Bernanke.

The consensus from market experts has been the Federal Reserve didn’t taper because the economic data didn’t support a reduction. If Poole is right, and QE is not materially affecting the economy then the Fed won’t find the numbers it is looking for. Given the huge amount of liquidity sprayed at the US economy, you would expect the gap between Treasury bond yields and mortgage rates to have narrowed. That hasn’t happened, nor has bank credit responded as expected. It is still below pre-GFC averages, and after an initial spike when asset purchases commenced in 2009, credit growth is now heading back toward zero. Finally, the amount of money turned over in the US economy has not moved any higher than historical trend.

Wall St. seems to be ignoring these profound problems. Instead, investors react to commentary from the Federal Reserve which can violently move markets. 

Poole says that asset purchases should be stopped all together. By reducing the purchases in an orderly fashion by $10 billion per month, it could be done and dusted by the end of 2014. That would have two important effects. First, it puts the issue behind the incoming chairman. This makes sense – if the bond yields reacted so decisively when they were only concerned about tapering, why not actually do it.

Secondly, the longer quantitative easing goes on the greater problems the US could face in the future as bank balance sheets become increasingly inflated and inflationary outcomes complicate the situation further.