Forget Tapering, and Get Ready For QE4

Markets have been excessively spooked by the prospect of Fed "tapering." If economic performance holds steady and inflation remains low, the Fed could start reducing the pace of its bond purchases by year-end. It is more likely that the Fed will have to reverse itself and start talking about "un-tapering" or QE4 at its December meeting.

By John Makin
September 4, 2013
Real Clear Markets

Markets have been excessively spooked by the prospect of Fed "tapering" (reducing bond purchases). Rates on long-term treasuries have risen by 100 basis points since hints, first voiced by Chairman Bernanke at his May 22 JEC testimony, that if economic performance holds steady (growth above two percent and unemployment falling) or improves and inflation remains low (it is actually falling, to a one percent or lower pace), the Fed could start reducing the pace of its bond purchases (QE), by year-end. It is more likely, in view of the negative impact on the already weak U.S. economy arising from the higher interest rates resulting from taper talk, that the Fed will have to reverse itself (again) and start talking about "un-tapering" or QE4 at its December meeting.

The Tapering Trauma

Since May, many in markets have convinced themselves that the Fed will actually start tapering at its September meeting. Most are calling for modest unwind that reduces the Fed's monthly bond purchases by about $20 billion, from $85 billion to $65 billion per month. As noted already, and perspective homebuyers know well, fears of this and further tapering have also boosted mortgage rates by a full percentage point, from about 3.5 percent to 4.5 percent. That jump creates a big reduction in housing affordability, at least an extra $200 per month on a $240,000 mortgage.

Higher mortgage rates have spooked both homebuilders and home buyers. June housing starts plunged by over 9 percent month-over-month while building permits, often a forerunner of housing starts, fell in June by nearly 8 percent month-over-month. July saw only partial reversals of June's very weak data, and July new home sales plunged by 13.4 percent month-over-month, the largest drop in more than three years.

Tapering Down the Taper

There are three reasons to expect reversal of the higher interest rates and the taper talk that have emerged since May. First, the supply of treasuries coming to markets (government borrowing needs), by virtue of a sharp reduction in the heretofore $1 trillion budget deficit, drives down interest rates. The deficit has been reduced by about $400 billion, due in large part to tax increases enacted in January 2013 and spending cuts that are continuing to result from the March 2013 sequester. Ongoing deficit reduction will reduce treasury borrowing needs even further in coming years by an average of $400-500 billion per year relative to 2012 levels. If, for example, the Fed cuts QE bond purchases by $20 billion per month in September, as some have suggested, there is an actual reduction in the supply of bonds for markets to absorb in the 2014 fiscal year that begins on October 1, 2013. Given the sharp drop in deficits, the Fed can cut bond purchases by about $40 billion per month - $480 billion per year - and leave the net supply unaffected based on post-2012 deficit reduction.

Another reason for the reversal in "taper trauma" interest rate increases is the slowing of the U.S. economy that is currently underway. Forecasts of third quarter growth (the official figure will be released on October 30, 2013) have softened from about 2.5 percent in early August to 1.5 percent in early September, perilously close to a one percent stall speed. The slowdown is a natural result of early 2013 tax increases and from spending cuts tied to the sequester that imparted a 2013 "fiscal drag" equal to about 2 percentage points of GDP growth. Slower growth means less borrowing by households and firms and lower interest rates.

The economic slowdown that is frightening the Fed, along with numerous U.S. households and businesses, produces a policy feedback effect that is also supportive of lower interest rates. Slower growth has pushed the Fed to temper its recent taper talk. Sustained QE at $85 billion per month, to be announced after its September 17-18 meeting, is becoming more likely as the Fed is pushed to return to full support of the slowing economy by employing sustained QE.

A third reason for interest rates to fall back toward April's record low levels, and perhaps, for QE to rise back-to-or-above April's record high is tied to a persistent drop in inflation that has appeared since mid-2011. The core personal consumption expenditures (PCE) price index stayed at 1.2 percent in July, well below the 2 percent Fed guideline (see figure 1). Lower inflation lowers expected inflation and thereby reduces market interest rates. Also, lower inflation pushes the Fed towards more QE. QE2 resulted from a mid-2010 "deflation scare" which Chairman Bernanke cited during his August 2010 Jackson Hole conference speech.

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