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Why ‘Tapering’?

UPDATED:

Lately, the press has been beating their drums about the winding down of QE3 (Quantitative Easing 3) and the fancy name for the process is called ‘tapering’. The pundits insist inflation is soon to follow. After all of this money printing, certainly, inflation is on the horizon, right?

How does tapering (QE3) affect the economy?

The Federal Reserve uses monetary policy to guide the economy. The Fed has two goals: 1) Provide stability to the financial markets and 2) Control inflation It could be argued that when push comes to shove (and it often does) the Fed will temporarily disregard inflation if stability is in question. We are now nearing the end of that precise type of cycle. After the entire system came into question in 2007-2008, stability to the markets took center stage. In order to get markets to flow after this economic shock, the Fed took unprecedented measures. Covertly, they manipulated the players like Lehman, Merrill, Bank of America, FNMA, GSA, etc. Overtly, they supported financial flows including increased FDIC insurance, flooded the markets with cash (bought debt), eased interest rates, changed the rules at the discount window, and even supported stocks- taking equity in several companies, etc. Fortunately, the Fed can look back over the past 5-6 years and affirm that they have stabilized the economy (domestically and internationally). Now it’s time to get back to part two of their agenda; controlling inflation.

Monetary policy is constantly manipulated by the Fed

Monetary policy manipulation is nothing new. What is new, however, is the transparency of “Fed Speak” and the process the Fed used to implement their policy tools. In the past, the Fed wouldn’t announce policy changes. Specialists and insiders would de-cipher Fed jargon and Treasury trades to queue rate directives. Today, the Fed routinely announces their intentions publicly. In the past, monetary policy was generally concentrated in the short end of the yield curve (short-term interest rates) in hopes that long-term rates would follow in unison. However, Quantitative Easing ( QE, QE2, QE3) is aimed directly at long-term rates. It intentionally relieves rates on mortgages, which is where the root of the previous ‘easy money’ crisis began. Mortgage burdens have eased significantly since, as millions of homeowners used this window of low long-term rates to refinance their debt and immediately improve current cash flow.

Does tapering definitively cause inflation?

The prevailing wisdom is that QE3 will lead to a spike in inflation as cheap money will fuel more speculative excesses. We believe there is enough slack in the economy and strong demographics at work that will counter these forces. As the process ‘tapers’, some players may scramble to borrow and force rates even higher temporarily. But interest rates returning to pre-stimulus prices won’t have a long-lasting push on inflation. As a matter of fact, they should actually slow the economy as borrowing costs rise. The Fed realizes if they just turn off the spigot overnight, they would shock the system. Also, it should be noted that the average amount of cash on hand at corporations has swelled to over 20% of assets! The odds of these companies borrowing needs pushing interest rates significantly higher seems far-fetched. Will these companies really need to rush out to borrow!?! UNLIKELY… A normalization of interest rates will probably allow these companies to put their money to work by lending (buying debt)!

Demographics at work…

Enter the baby boomers. Baby boomers are heading into retirement in droves. They have spent the last 6 years chasing yield and trying to stretch their dollars further and further in an abnormally low-interest-rate environment. These people will use any increase in interest rates to put their cash back to work too! Money Market rates and CD’s have paid so poorly, that many have taken more risk than they should carry. Higher interest rates will allow baby boomers the chance to improve their cash flow going forward.  They will earn more as they purchase fixed income products (Treasury, CD, Money Market, and Corporate Bonds) once they retire. The re-normalization of interest rates is a welcome sign that the economy is continuing in the right direction. Furthermore, the fact that the Fed believes it could now address the possibility of inflation, is encouraging. Quantitative Easing has dramatically helped people and institutions refinance their debt obligations and improve cash flow when money was tight. “Tapering” will allow those awash in ‘cash’ to put their money back to work without shocking the system. The combination of demographics and historically large amounts of cash on hand will blunt most inflation pressures caused by a ‘normalizing’ of the interest rate environment.