Tapering or Tightening?
David R. Kotok
Cumberland Advisors, November 17, 2013
Janet Yellen did well in her Senate hearing. Markets have settled on the notion that Federal Reserve policy is not going to lurch abruptly in a new and surprising direction. The results are to (1) shrink risk premia, (2) add to the perception of some Fed policy predictability, and (3) marginalize the behavior of extreme senators like Rand Paul who would slow down the process.
Readers know we were critical of Senator Paul when he threatened to put a senatorial “hold” on Janet Yellen’s nomination. Yahoo-Finance’s Daily Ticker issued an invitation to me to debate with David Stockman on the Rand Paul response. Here is the link to an excerpt from that debate: http://ph.news.yahoo.com/video/rand-paul-absurd-hold-yellens-152616134.html.
A second part of that debate had to do with stock markets and bubbles. My argument is that we are not yet in a stock market bubble, a housing bubble, or any other sort of bubble. We may get there, but we are not there yet. We are in a period of rising prices. David Stockman countered with the opposing argument and called for immediate action because of bubble conditions. (Here is the link to that section of the debate).
My colleague and Cumberland’s Chief Monetary Economist, Robert Eisenbeis, has written about the evolution of Fed monetary policy and tapering and what it means in the short and long run. Bob and I and others in our firm discuss this issue frequently.
In the national arena, there are those who wring their hands about quantitative easing (QE), offering gloomy predictions. For five years now, we have heard that monetary policy will result in a huge inflation. Look around. The inflation rate in goods and services is somewhere between 1% and 2% and is falling. Rampant inflation as the result of money printing, predicted by so many, has not happened yet. It is not likely to happen for a while. Falling inflation is likely to be intensified if commodity and energy prices also decline.
Others have debated whether or not the Fed’s tapering constitutes a tightening. The Fed and Janet Yellen maintain that tapering is not tightening, but that view is controversial. Let’s consider this metaphor:
A car is moving at 80 miles per hour with the driver’s foot on the accelerator. The driver’s foot is then lifted from the accelerator to slow the car to 60 miles per hour. During the car’s deceleration from 80 mph to 60 mph, the engine is not providing any power. At some point the car reaches 60 mph, still slowing; the driver then puts a foot back on the accelerator to maintain speed at 60 mph. The engine is now providing the power again (think of this as monetary stimulus) to maintain that new speed. At all times, the car is moving forward. The rate of movement changed, but the direction did not.
Does the metaphor apply to monetary policy? That is much harder because the question cannot be answered in a vacuum, without other influences. Such influences might include foreign currency exchange rates or foreign central bank activities and how they interact with the US dollar and economy. What happens when the structure of the credit markets changes? Does that have an impact on the tapering versus tightening debate?
We think the answer to that question is yes. Before Lehman-AIG and at the onset of extraordinary monetary stimulus, the weighted duration of the Fed’s assets was 2. The size of the balance sheet was approximately $900 billion. Today, the Fed’s balance sheet is $4 trillion in size, and the weighted duration is 6. These durations are computed as estimates of a weighted duration and derived from an examination of the construction of the various Fed assets. We have gone from $900 billion with duration of 2, to $4 trillion with duration of 6. That is a massive change in market impact. The November, 2013, McKinsey discussion paper estimates that the Fed’s special programs “have reduced ten-year Treasury yields by about 65 to 100 basis points.”
That is in addition to taking short-term interest rates to near zero. The longer-term rates were reduced because the Fed extracted the weighted duration from the market and put it on the central bank’s balance sheet. The central bank funded that transaction by creating excess reserves in the banking system. Those excess reserves are presently costing the Fed a payment rate of 0.25% per year. The Fed takes the differential between that cost of 25 basis points and what it receives on the long duration it holds on its balance sheet and then hands the difference back to the US Treasury. Those remittances now take place on a regular and systematic basis. They approximate $100 billion per year. The Treasury takes the $100 billion and uses it to reduce the budget deficit. That is the circularity of the transaction as it exists today.
What happens if the federal deficit shrinks? The US Treasury creates fewer new federal securities relative to the number created before this process started. A shrinking deficit means not originating as many new Treasury notes, bonds, and bills as were previously created. This is happening today. As Stan Collender wrote, “Deficit numbers, especially good ones, are just not that interesting.” So we didn’t hear much about it. Fact: the deficit is now under 4% of GDP and falling.
If the Fed holds its quantitative easing policy stable at $85 billion per month and the US Treasury creates less duration than it did previously because of the shrinking deficit, the Fed’s extraction of new duration relative to GDP is going up. The Fed is presently absorbing roughly the entire new duration created by the US government in the issuance of Treasury securities. There is a similar and parallel activity going on in federal mortgage-backed securities.
What does this mean when the Fed begins to taper? We cannot be sure. If tapering means buying fewer than $85 billion per month in federally backed securities and it happens at the same time the federal government is producing fewer such securities, it is quite possible that tapering will not be tightening. Both the Fed’s purchases and the creation of new Treasury securities are two sides of a shrinking deficit. Both can be reduced in a fashion where stability and neutrality can be maintained.
In our view, it is uncertain as to whether tapering results in any type of tightening. At the moment, we do not know the process for tapering, and we do not know the rate at which tapering will occur. We expect it to commence early next year and to be consistent with the criteria outlined in Janet Yellen’s and Ben Bernanke’s testimony and speeches.
All of this means that asset prices in almost all categories – stocks, commodities that reflect monetary activity, art in auctions, real estate, and a host of other items – reflect an upward bias. The reason behind that upward bias is that the interest rate is maintained at a very low level. When interest rates are maintained at a very low level, the discounting mechanism to value assets works to raise the prices of those assets. That trend will continue worldwide in the major economies for several more years as all of them go through this process of central bank stimulus, plateauing, subsequent tapering, reaching a neutrality level, and then confronting in the out years how to permit the assets of the central bank to roll off and mature over time without shocking those economies.
The last item will take place years from now. We remain fully invested.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors