The Perils of Tampering and Tapering by Guest Blogger Robert Klemkosky

Since May 22, volatility in most markets (stocks, bonds and currencies) has increased, not only in the U.S. and Europe, but also in Asia and especially in emerging markets. That happened to be the date that Fed Chairman Ben Bernanke testified before a congressional joint economic committee. In answer to a question about slowing the Fed’s monetary stimulus, he replied “If we see continued (economic) improvement and we have confidence that it is going to be sustained, then we could – in the next few meetings – take a step down in our pace of (bond) purchases.” He also warned that “premature tightening would carry a substantial risk of slowing or ending the economic recovery.”

The above response was in reference to the Fed’s most recent qualitative easing (QE) program called QE3 or QE Infinity. The two prior QE programs had definite purchase amount targets and schedules. QE 1 involved the purchase of $1 trillion of mortgage-backed and U.S. Treasury bonds in 2008 and 2009. QE2 involved another $600 billion of bond purchases from November 2010 to June 2011. QE3 was more open ended in that the Fed announced in August 2012 that it would purchase $85 billion of bonds each month until, later announced, the U.S. unemployment rate falls below 6.5 percent.

$85 billion monthly may not sound like much, but do the math, and it comes to more than $1 trillion annually. The QE programs have bloated the Fed balance sheet from $800 million before the financial crisis of 2008-2009 to $3.3 trillion today – four times larger in five years.

The purpose of the QE programs was to reduce long-term interest rates and increase asset prices, stocks, bonds and housing. By increasing asset prices, which has happened, less in housing than stocks and bonds, the Fed counted on the wealth effect and lower interest rates to increase confidence and stimulate consumer spending and corporate investment. The Fed also was concerned about deflation and has targeted 2 percent as the desirable inflation rate.

Bernanke’s response was certainly measured and cautions, and some have referred to it as “splitting hairs,” but it has created turmoil in the markets. Since then, bad has become good, and good has become bad in terms of economic news and market reaction. When the economic news is too good, long-term interest rates rise and bond and stock prices fall. If the news is bad, the opposite effect takes place. Investors prefer Goldilocks economic news, not too good or too bad.

As mentioned earlier, the QE programs have been successful in keeping long-term interest rates low, thus supporting higher bond prices; lower mortgage rates have helped increase house prices by 13 percent in the last year after a drop of 33 percent from peak prices in 2006; and the stock market as measured by the S&P 500 is up 140 percent from the low of March 2009. How about its effect on the U.S. economy? Who knows what the U.S. economy would have been like without the QE programs, but their impact has not been as dramatic as the Fed had hoped them to be.

June 2013 marks the fourth anniversary of the present economic recovery. Economic growth has averaged around 2 percent during the four-year economic recovery period – one of the slowest recoveries in the post-WWII era. Even though economic growth was 2.4 percent in the first quarter of 2013, the 15 quarters of growth have been very uneven, from highs of 4 percent in the fourth quarters of 2009 and 2011 to lows of less than .5 percent in the first quarter of 2011 and the fourth quarter of 2012. Plenty of hopes and disappointments for U.S. economic growth.

Employment and job creation has been one of the biggest problems in the recovery. There are still 2.5 million fewer people employed today than in 2007, and the unemployment rate remains high at 7.6 percent. For many, it has been a jobless recovery. The private sector of the economy has done a better job of creating employment than the government sector, which has shed more than 1 million jobs at the state, local and federal levels.

But the operative word now is tapering; when will the Fed begin to gradually reduce its $85 billion monthly purchases of bonds, and when will it stop completely? It seems the market has become, if not addicted, fixated on the supposed benefit of the QE monetary stimulus, and thus the bad news is good news scenario. But no matter when the start of the tapering or the end of QE3, the Fed cannot keep purchasing $1 trillion of bonds each year. While inflation and inflationary expectations don’t appear to be a problem in the short term and even out to five years, continued monetary stimulus could result in inflation in the longer term – especially given the fiscal and monetary stimulus undertaken recently by Japan and the Bank of Japan as well as the Eurozone and the European Central Bank.

Eventually normalcy for the economy hopefully will prevail, and real interest rates will then become more positive, which means that nominal interest rates will rise. The 10-year U.S. Treasury bond yield has already recently increased from 1.6 percent to 2.4 percent, but even 2.4 percent is a historically low rate. The question is when will rates rise further? Given all of the uncertainty, it is not obvious to investors. But a return to more normal economic growth without fiscal or monetary stimulus may be a welcome and positive event for investors. It has been six long years since the Fed got so entangled in the economy. Less entanglement should be a huge positive, but it will create uncertainty and risk, especially for the bond markets. But tapering will be better than tampering. It will mean a return to normalcy. The Fed only needs to signal its exit plan with clarity and less opacity so investors are not left guessing as now.