Is the Fed an Enabler?
David R. Kotok
Cumberland Advisors, September 21, 2013
An unintended consequence of not tapering is, we think, that the Fed has become an enabler of more Congressional dysfunction.
One of the most distressing elements of the Fed (Federal Reserve) decision this week is the introduction of a new and embellished notion that the Fed is delaying its reduction of stimulus, or tapering, which is otherwise known as a pathway to some policy neutrality, until the deficit, debt-limit, sequester political fight is resolved. That is a newer element in the Fed’s rhetoric. We saw references to it in the Bernanke press conference, and we have since seen additional references.
Think about what this means. It means that the Fed has added a political element into its decision-making process. Fed policy used to be clearly based on economic indicators like the rate of inflation, inflation expectations, market anticipation of inflation, and how inflation was priced into market-based asset prices and other measures.
The other element in Fed policy making has to do with the rate of real growth. That element includes the status of employment, unemployment, the employment participation rate, the employment of part-time workers vs. full time workers, and the labor-related elements that reflect the recovery of the economy. In fact, the Fed set forth policy targets and thus created this notion of targeted “forward guidance.” The Fed has said repeatedly that it is targeting an unemployment rate goal of 6.5% and declining, and has reaffirmed that goal. And the Fed has targeted an inflation rate of 2%. It has said and reaffirmed that it would permit inflation to be 2.5% before it would trigger action. That is what the Fed said over and over again for a prolonged period of time.
For the last several years, Fed commentary, minutes, discussions, rhetoric from speakers, and paper presentations did not emphasize that Fed policy would be modified to deal with political impasses. Some of the impasses for which policy modifications were not emphasized included the failure of Congress and the president to agree on debt limits, debt ceilings, sequesters, the defunding of Obamacare, and other machinations. Those antagonistic antics come out of a different quarter of Washington, not the Eccles Building that houses the Fed.
The introduction of politics into Fed decision making creates a new and immeasurable uncertainty. Therefore it creates an uncertainty premium. Remember, uncertainty premia add to volatility in both directions, as we saw in the market explosion following the Fed’s surprise announcement and as we saw yesterday. We cannot forecast the degree to which these forces will work to increase volatility in either direction. We got a dose of the negative side on Friday just as we got a dose of the positive side following the Fed’s surprise. Was the Friday selloff due to St. Louis Fed president Jim Bullard’s indicating that the Fed might change its tone very soon and taper at the next meeting? There is no way to know. Was it due to the congressional impasse? No way to know. Maybe it was due to both.
By introducing the notion that Fed policy making has been delayed because of political impasses, the Fed has added another wobbly leg of uncertain length to an already unstable stool. The former legs on which Fed policy was based included an expectations component and other more measurable functions. We knew what they were made of, more or less, and we could measure them. But there is no way to measure the predictability of a politically deadlocked impasse and a structurally flawed political decision-making system.
What has the Fed wrought by not tapering a small amount – say, $10 billion or $15 billion a month? By deferring that decision and mentioning the political impasse risk, the Fed may have has enabled an undisciplined Congress, giving it more leeway to misbehave. Has the Fed removed a pressure, a curb that it could otherwise apply as an independent central bank? Instead it has allowed politics to enter the central bank decision-making process in an even deeper way than politics have already done.
What does all of this mean for policy making? We do not know. The Fed does not know. The markets are only now developing an expectation that the expected tapering will come later but not that much later. Markets assume it will be gradual but are not sure of that, either. When to taper and how much to taper has again become unpredictable. Since Bernanke’s press conference, we have seen a range of estimates: some suggest that tapering will commence at the October meeting, others expect it to be initiated at the December meeting, and still others hazard that there will be no tapering until the end of 2014. All are only guesses; no one knows. How does a market agent make a decision under these conditions? It is difficult. Thus risk premia rise and the Fed defeats its own goal of shrinking them.
Now add to this uncertainty the deficit fight. The peaking of the deficit in the US was at an annual run rate of $1.4 trillion. That’s right; $1,400 billion of net new federally backed Treasury securities were being created at an annualized rate. The latest budgetary indications from the Congressional Budget Office have led analysts to derive an estimate suggesting that a great deal of that “fiscal drag” is now behind us. It would appear that the annual run rate of the federal deficit is now approximately $400 billion instead of $1,400 billion. That is a huge change.
As of today, the Fed is positioned to continue its asset purchases at a rate that exceeds, on an annualized basis, the entire creation of net new federal debt securities for the US. In other words, the US central bank is buying more than 100% of the net debt instruments created by the US Treasury. Not only are they absorbing the entire deficit, they are also absorbing holdings from other institutions both within and outside the US. The rest of the world sells federal securities to the Fed, a bidder that has unlimited ability to pay for them.
Current Fed policy is very bullish in the short term for market instruments and for those assets that are attached to them, but it is a policy that is very dangerous in the long term. Everyone in the Fed and all market agents know it cannot continue forever.
Here we have arrived at the crossroads of a great debate. The short term is very bullish and driven by policy. That policy now factors in a political sensitivity introduced by the Federal Open Market Committee and the Federal Reserve Board of Governors. Long-term, it is an unsustainable policy. We know it cannot continue forever.
We know that when it ends, the wind-down becomes a game of musical chairs. We know the management of that transition will be very difficult. We also know that markets will anticipate the change. They will act before the policy change is announced. And in so doing, they may make the policy change more difficult. That is what happened in June, July and August. By waiting to taper, we believe that the Fed has made the next round more volatile.
The Fed is now engaged in a game of musical chairs unlike any other it has conducted in the past. In musical chairs, the music stops, and someone does not get a seat. The Fed is trying to manipulate the game by slightly adjusting the volume of the music. At their last meeting, they maintained the volume after suggesting that they were going to turn it down a notch. When they do turn it down a notch, even in a small way, markets are likely to be very volatile. If on the other hand they do not turn it down a notch, markets are likely to be very volatile. The Fed’s failure to deliver a very small tapering at this last meeting has raised volatility and the market’s response to any change in the volume, however small.
We have again raised a cash reserve. We are still buying longer-term tax-free bonds. They remain cheap. All this Fed activity has raised risk premia, and that means the economy will recover more slowly. Had the Fed tapered a small amount in keeping with the expectation that the Fed itself created, risk premia would likely have fallen instead.
That is my opinion (though we cannot test it, since the Fed did not initiate tapering), and it is being applied by this portfolio management firm. Even a $5 billion taper would have sufficed. No taper, however, was a mistake when the Fed is sitting on $2 trillion of excess reserves and the amount is rising monthly.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors