The Fed’s Taper and Market Fealty

The Fed’s announcing the taper was supposed to be an earth-shaking event. But that actually sorta happened last summer when Bernanke first used the “t” word and interest and mortgage rates made an impressive upward march in a short period of time.

From my considerable remove, what was noteworthy about the Fed’s announcement yesterday is how terrified it seems to be of creating an upset. This in and of itself is pretty odd, since other central banks are still engaged in QE and/or aggressive liquidity creation (Japan is going to do even more soon) so as to make the impact of any move by the Fed not that consequential in isolation.

And that’s before you consider the historical evidence that undoing QE did all of…bupkis. As Philip Pilkington writes:

There are two things that are particularly odd about all the tapering talk — two things that are tied up with one another. The first is that there is talk at all. If tapering evidently makes rather little difference to the markets and the economy then why do the press and financial analysts talk about it endlessly? The answer to this is rather simple: it is the nature of the press and wider society to talk about people and institutions that are perceived to wield power…

The second thing that was rather odd about all the tapering talk was the constant reference to the supposed fact that it had never been done before, that we were entering uncharted waters and that it was hard to predict what effect such tapering might have. This was just complete and utter rubbish.

In actual fact, as I noted on FT Alphaville back in April, a far more extreme version of tapering was undertaken by the Japanese central bank (JCB) in early 2006. In this period the central bank didn’t just slow the rate of purchases as the Fed are now doing but instead shrank their balance sheet. And what were the effects? I cannot find any serious effects in the data.

As I noted in that post there was no obvious correlation between QE and inflation or the exchange rate or GDP growth. The shrinking of the JCB’s balance sheet also appears to have had no effect on the stock market which continued to rally until the onset of the financial crisis in late-2007/early-2008.

So, why is no one reporting on this? Surely this should be a worthy news item. Given that barrels upon barrels of ink that are expended daily reflecting on the significance of the taper surely the press should be interested in considering a far more substantial move away from QE. Not really. That would be the equivalent of revealing that the emperor has no clothes.

Now I’ll differ with Pilkington a tad. QE did have some effects, but I doubt NC readers would seem many of them as significant or all that salutary, given where unemployment sits. Unlike Japan, US mortgages are mainly fixed rate but borrowers can refinance freely. The refi boom provided banks with income and some consumers with lower mortgage payments. So this was a prop to bank income and an indirect and not very strong form of stimulus (the banks take a lot out in fees, so the consumer relief was not as great as you might hazard). We also had other behaviors you would not have seen in Japan, such as corporations issuing bonds like crazy and building up large cash hordes, and in many cases buying back their own stock. Oh, and it did encourage private equity firms to rush out and buy a lot of single family homes to rent. We suspect in many cases the results will not be pretty.

But even if the Fed now recognizes that QE wasn’t terribly effective, their desperate signaling to the market that they won’t do anything to rattle it is really unseemly. Income inequality has risen dramatically since the crisis, and using the wealth effect to try to provide some lift to the economy is perverse, an indirect entrenchment of this aspect of a bad status quo. The Fed seems reluctant to recognize that low interest rates no longer provides much stimulus to the economy because the housing model, which was the main transmission channel in past recoveries, is broken (See Matt Stoller’s Fordham Fordham Urban Law Journal article, The Housing Crash and the End of American Citizenship, for a long-from discussion). Low household formation, high debt levels among the young (and student debt as senior debt!), distrust of housing (rational given predatory servicing and undue emphasis on “housing as an investment”) and ironically, the success of the “prop up housing prices” effort limiting affordability all contributed to the limited impact of QE (not that I am certain it would have worked even then; the Bank of Japan was first to experiment in the late 1980s with using the wealth effect to boost consumption, and we know how that movie ended).

The Fed also weirdly never seemed to get that banks aren’t lending primarily because there is little demand for loans among small businesses (they borrow to exploit opportunities, which are few in the new normal, unless you are in a countercyclical enterprise) and because banking has become so concentrated. The central bank has happily allowed banks to become fewer and bigger even before the crisis. But megabank run their branches like stores, and allow manager little discretion. That means they don’t engage in character-based lending and aren’t able to use local market intelligence to inform small business lending decision. The result is that they’ve pretty much ceded that business to community banks and credit unions, but they aren’t as big a channel as in the old days when there was more diversity in banking and the bigger banks had some participation in this sector.

The Fed has undergone a complete reversal since I was a young thing in the finance business. It used to relish the role of taking the punchbowl away. It now seems terrified of even reducing the alcohol level of the brew. This all goes back to Greenspan. My pet theory is he was very much imprinted by the stock market crash of 1987, which was early on his watch, and he got lots of praise for handling it well. He was also obsesses with how stock market prices were formed and apparently set a lot of Fed talent to studying that question. And Bernanke clearly embraced Greenspan’s equity-fixated view. Recall that Bernanke’s famous 2002 speech about deflation, in which he set forth the extreme measures the Fed could use to fight deflation, was triggered by fear that the dot-com bust would trigger deflation. This was an astonishing belief, since the stock market bubble did not involve a significant amount of borrowings and its implosion did not blow back to the financial system.

The final problem is mission creep. The Fed has abandoned its independence (despite its claims to the contrary; an independent Fed would stay silent on matters like Social Security and budget policy) and has also unwisely allowed itself to be seen as the possible savior of the economy, when any heroic efforts should be made thorough government programs, not unaccountable central bank initiatives. But since Greenspan, the Fed enjoys its Oz-like image, even if it had deployed its stage-magical powers to fight chimeras.

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  1. MikeNY

    Excellent post.

    In the old days, stock values were supposed TO REFLECT the prospects for the economy; now, they are manipulated TO DRIVE the economy. It is a$$-backwards. The Fed has become a reactionary institution, in thrall to the plutocrats, complicit in Congressional dereliction, and clinging fanatically to a feudal doctrine of “trickle-down”.

    1. susan the other

      +100. Even Greenspan is now backpedaling how effective the Fed was at controlling interest rates. Makes Mexico’s comment (below) way interesting – that interest rates are pure politics. The question becomes, Why even indulge the myth of the Fed? Why not MMT? Of course there will always be a frying pan and a fire. There is no guarantee MMT will be uncorruptable given our sleazebag Congress and military heavies. The military is the one institution that always wins – it always gets its financing. That’s probably the reason the hard right caved and did a weird and useless compromise budget. Just to cover military expenses.

      1. MikeNY

        Well, if you’re a plutocrat, you may need the troops to protect you someday… gotta keep them happy. Any third-world dictator or divine-right monarch worth his salt will tell you that!

  2. Adriannzinha

    Take a gander at CNBC or Bloomberg for even a few minutes and the financial talking heads berate “entitlements” like SS and Medicare, disparage the idea of living wages, and lament the allegedly massive amount of government aid in the form of welfare.

    Meanwhile Wall Street’s Welfare comes from the Treasury but that’s not a problem, just ask the same pundits.

    1. Carla

      Re: CNBC and Bloomberg: on NPR they diss Social Security and Medicare every day, too.

      But I wanted to read the Matt Stoller link in Yves’ post , and when I went there, this is what I got:

      AUTHOR(S)Stoller, Matt
      PUB. DATEMay 2012
      SOURCEFordham Urban Law Journal;May2012, Vol. 39 Issue 4, p1183
      SOURCE TYPEAcademic Journal
      DOC. TYPEArticle
      ABSTRACTThe article focuses on the evolution of the housing system in the 20th century in the U.S. It notes that the housing market crash altered the power and wealth distribution mechanisms for the country’s political order. It stresses that the country’s foreclosure epidemic of the 1930s signals the end of American citizenship and the beginning of a period of political and economic instability.

      It also said ” this is available at your local library, but Carla, not at YOUR local library.” Well, that’s okay because I didn’t really want to read about the foreclosure epidemic of the 1930s. Would rather learn about the one I’m still smack in the middle of right now.

      There are so many errors online and they compound and compound.

      ….the foreclosure epidemic of the 1930s????

  3. Alejandro

    If risk is a recognition of “Murphy’s law”, when something does go wrong it is reality asserting itself via limits. If interest is a measurement of risk, or at least an estimate, then compound interest is a scam, or at least a deluded denial of limits. If greed is blinded to limits, then regulation is an imperative….Hows that for reverse “presuppositioning”.

    “According to an old legend, vizier Sissa Ben Dahir presented an Indian King Sharim with a beautiful, hand-made chessboard. The king asked what he would like in return for his gift and the courtier surprised the king by asking for one grain of rice on the first square, two grains on the second, four grains on the third etc. The king readily agreed and asked for the rice to be brought. All went well at first, but the requirement for 2 ^ n − 1 grains on the nth square demanded over a million grains on the 21st square, more than a million million (aka trillion) on the 41st and there simply was not enough rice in the whole world for the final squares. “
    – Porritt, Jonathan (2005). Capitalism: as if the world matters. London: Earthscan. p. 49.

    1. from Mexico

      If interest is a measurement of risk?

      In many cases interest is not a measurement of risk. It is a political decision, and interest rates are what policymakers decide they are going to be. Take, for instance, the interest rate the U.S. Treasury pays on the U.S. sovereign debt. Is there any circumstance under which U.S. policymakers cannot decide what this rate is going to be?

      Even when interest rates are not determined by policymakers, in those situations where the market determines interest rates, risk often has nothing to do with interest rates. More often than not, purely psychological factors have more impact on interest rates than actual risk.

      And here’s a question for those who believe interest is a measurement of risk: Why should Brazil pay a higher interest rate on its external debt than Turkey? Turkey’s financial fundamentals are an utter basket case in comparison to Brazil’s. Could the fact that Turkey dances to the neoliberal tune of the transnational financial overlords have something to do with it? Remember when President Nixon ordered the CIA to “make the economy scream” in Chile to “prevent Allende from coming to power or to unseat him.”

      Some prognosticate that such an effort is now underway to undermine the economy of Brazil:

      “Globalization is deglobalizing and the grand powers of a geostrategic tripolar world (US/Russia/China) are divvying up their respective spheres of influence, in which Brazil is left behind due to the brutal counteroffensive of the United States (e.g., the The Trans-Pacific Partnership) and the financial war against the markets in Sao Paulo.”

      Alfredo Jalife-Rahme, “Bajo la lupa: The privitization of Pemex and the US’s war against China”

      1. Chauncey Gardiner

        Re your last sentence, Mexico: Yep, the joy in Mudville media was palpable as the colony was brought back into the fold, whether by hook or by crook. Too bad the reserves are mostly tight shale and deepwater in a world in denial. But it’s all about kicking the can now.

    2. Chauncey Gardiner


      Great story, Alejandro. Thank you! What if the veins of debt under the fractional reserves banking system have all been largely mined out except for increasing the “public debt”? (Is it debt at all when money issuance is controlled by the sovereign?)… to the point where those in control of the status quo are immersing the young in debt and preventing or causing deferral of household formation?

      I recall that another reader here, Hugh, said many months ago that we are operating under an artificial gold standard. I would agree that in one sense he is right. But in another, we already have the unrecognized equivalent of MMT without the upside.

      How do you spell seigniorage as the global reserve currency?

    3. diptherio

      Traditionally, I think, interest is justified as being the opportunity cost of money…but maybe I’m misremembering my training…compound interest, however, is definitely a scam, whichever way a person tries to philosophically justify interest rates.

      I prefer Proudhon’s Mutualist banking, wherein the cost of borrowing is the cost of maintaining the bank and its employees…i.e. no profits, strictly speaking. Bank employees would be salaried and Proudhon figured a rate of about .5% on loans (a straight .5%, not compounded) would be enough to pay the bills.

      1. F. Beard

        Even 0% interest loans of new purchasing power from government privileged banks violate Equal Protection under the Law since no one is worthy of his neighbor’s confiscated (via dilution) purchasing power.

        Credit creation, unless by the government for the general welfare, should be an entirely private matter since no one is creditworthy of the public’s purchasing power.

  4. from Mexico

    Yves Smith said:

    “Now I’ll differ with Pilkington a tad. QE did have some effects…. The refi boom provided banks with income and some consumers with lower mortgage payments. So this was a prop to bank income and an indirect and not very strong form of stimulus…”

    I wonder too about interest rate spreads — the interest rates banks must pay to borrow money vs. the interest rates they lend it out at.

    As Wikipedia explains, QE brings down the interest rates banks pay for money:

    “A central bank implements quantitative easing by buying specified amounts of long term financial assets from commercial banks and other private institutions, thus increasing the monetary base and lowering the yield on those financial assets.”

    The first round of QE, which began in November 2008, appears to have greatly aided the banks by increasing their interest rate spreads, as this graph illustrates:

    However, as the graph shows, QE2 and QE3 have not been as successful in this regard.

    Nevertheless, what effect would ending QE have on the banks’ interest rate spreads? Would it not have the effect of driving them down further?

    1. James Levy

      The banks can always raise the rate they charge their customers and keep their spread. Or they can shunt even more of their capital into arbitrage operations. The government won’t stop them from doing either of those things, as it is now completely intellectually and emotionally captured (forget about campaign contributions) by the FIRE sector. This is a variation on Hobsbawm and Paul Kennedy’s “invisible income” thesis. America just added monetizing real estate appreciation to the mix of interest, fees, rents, and dividends that Britain became dependent on to make up for her chronic balance of payments problems. Building, selling, securitizing, and borrowing against the value of real estate assets created a vast fund of capital that the Americans used to boost economic growth, export the junk paper to buy back dollars, and to invest overseas and buy up key junctures of supply chains around the world. When this spigot was turned off in 2008 America’s comparative advantage went with it. But the Americans had sown poison pills throughout the system in the form of CDOs and Swaps so no one has been able to take advantage of America’s discomfiture. But a key element in American economic hegemony is broken, and all the king’s horses and all Obama’s men can’t put it back together again.

      1. from Mexico

        Just for fun, I went and looked at the Federal Reserves H.8 Assets and Liabilities of Commercial Banks in the United States for Nov. 2013 and Nov. 1990.

        In 1990, loans and leases made up 63.5% of the banks’ assets. By 2013, that percentage had dropped to 52.8%. So it looks like banks have shifted thier business away from making loans to other endeavors.

          1. Aaron Layman

            Interesting data point for sure, but not too surprising. That “other endeavors” thing is what has me concerned. I suppose we’re to keep our blinders on and regurgitate the message “tapering is not tightening”. LOL!

          2. Carla

            Don’t the banks own commodities now? In 1990 were they permitted to do that? If I’m way off base, just tell me.

  5. Dan Kervick

    My feeling is that a movement toward a more activist Fed is not the work of just a few figures, but is a direct consequence of the bipartisan neoliberal consensus around shrinking the federal government and reducing its importance in stabilizing the economy and charting a national strategic economic direction. If you are going to hand almost everything over to the private sector, you need to leave one place for stabilization policy from the top. The Fed is it. The center-left neoliberals are desperately committed to the idea that stabilization can be accomplished entirely through central bank monetary and interest rate policies. They need to believe this, because if it is wrong, they have to choose between Austrian style laissez faire or a return to the mixed economy ideals of the mid-20th century.

  6. Mark A. Sadowski

    Here’s a graph of RGDP of Japan, the U.S., Germany and the U.K. indexed to 100 in 2007Q1:

    The BOJ reduced the monetary base by 24.4% from January to November 2006 and economic weakness followed within months. Japan was one of the first major economies to have negative RGDP growth when it fell in 2007Q3. RGDP fell 4.7% at an annual rate in 2008Q2, and 4.0% at an annual rate in 2008Q3, causing Japan to suffer serious consecutive quarterly declines in RGDP before the U.S. did the same. RGDP proceeded to fall 12.4% at an annual rate in 2008Q4 and 15.1% at an annual rate in 2009Q1. All told RGDP fell 9.2% from peak to trough.

    In short, Japanese RGDP fell sooner, faster and further than every other major country this recession. It’s hard not to connect the dots between this result and the BOJ’s sudden and sharp withdrawal of QE, given one literally followed upon the other within months.

      1. Mark A. Sadowski

        I’ve cautioned other people about using Trading Economics figures in the past. I find them to be error prone.

        I have the Japanese Cabinet Office figures for real government consumption spending in front of me and find no correspondence at all with those figures. Here’s what I see (billions of real (2005) yen):
        2005Q1 92,622.40
        2005Q2 92,336.90
        2005Q3 92,237.80
        2005Q4 92,526.00
        2006Q1 92,157.00
        2006Q2 92,627.80
        2006Q3 92,633.00
        2006Q4 92,421.50
        2007Q1 92,872.00
        2007Q2 93,557.30
        2007Q3 93,360.30
        2007Q4 94,131.30
        2008Q1 94,054.70
        2008Q2 92,993.50
        2008Q3 92,948.30
        2008Q4 93,375.50
        2009Q1 94,223.20

        Observe that real government consumption spending was more or less constant during 2005 and 2006 but started to increase in 2007. I have no explanation for why this occured as there is no record of any fiscal stimulus during this period.

        There was a sudden decline in real government consumption spending in 2008Q2. This decrease is equal to 1.06 trillion yen which is about 0.2% of GDP (RGDP=523.5 trillion yen in 2008Q2) which brought real government consumption spending close to its level before the increase. Assuming a fiscal multiplier of 1.0 that would have reduced RGDP by 0.8% at an annual rate in 2008Q2. Given RGDP fell at a 4.7% annual rate that quarter that really doesn’t go very far in explaining the sharp decline in output.

        In short, the decline in real government consumption spending in early 2008 wasn’t really that dramatic when put into perspective.

    1. curlydan

      Tapering or ending QE does not equal a 24% decline in the monetary base, and if you look at the months preceding January 2006 in Japan, you’ll see no real QE going on or any outlandish growth in the monetary base. The CAGR in Japan’s monetary base from Jan 2004 to Jan 2006 was only 2.6%…that’s hardly QE.

      Call it what it is: a drastic reduction in the monetary base.

      1. Mark A. Sadowski

        “Call it what it is: a drastic reduction in the monetary base.”
        I thought I (more or less) did.

  7. Yancey Ward

    I will believe the taper when the taper actually happens. I will believe QE has ended when QE has actually stopped.

  8. Shrek

    What’s the point of announcing a taper, but making it conditional? We’ve seen growth disappoint and then they come back to with even more money printing. How does a normal person understand what the fed is doing? its printing money to borrow, but it owes the money to itself? What kind of distortions could that be creating?

  9. Jackrabbit

    The Fed has abandoned its independence (despite its claims to the contrary; an independent Fed would stay silent on matters like Social Security and budget policy) and has also unwisely allowed itself to be seen as the possible savior of the economy

    I believe that positioning the Fed as savior was deliberate. It made extending the Bush tax cuts and then making most of them permanent politically palatable. I think this is the most publicly visible aspect of the Fed’s loss of independence, not a separate matter.

  10. Paul Niemi

    Flip Quantitative Easing around and look at it another way. In 2012, the Fed paid the Treasury $89 billion in proceeds from its balance sheet income. As the balance sheet has reached $4 trillion, we may expect the revenues to the Treasury to be over $100 billion this year. Let’s grant that half of the purchases have been Treasury bills, but the other half have been private securities, and these have been bought for excess reserves held at the Fed for a small amount of interest. How can there be any stimulative effect? Perhaps by selling good assets to the Fed in exchange for reserves, the large banks have built up reserves necessary to pass stress tests. However, the net stimulative effect could be zero, because the stimulus of buying the T-bills is offset by the removal of a similarly-sized revenue stream from the private sector represented by the other securities. This is equivalent to a back door tax increase, used to get around a Congress where tax increases are anathema. Sure, the government needs the revenue, but it is like your local county commission borrowing to buy the local racetrack and putting the ticket revenue in the general fund. You can run a government off of rents and royalties, but sooner or later it becomes obvious that the government isn’t capable of managing such assets wisely. I don’t think for a moment the Fed has been independent in its QE program. My surmise, however, is that Treasury has been calling the shots predominantly and not the banks.

  11. Moneta

    The Fed seems reluctant to recognize that low interest rates no longer provides much stimulus to the economy because the housing model, which was the main transmission channel in past recoveries, is broken
    I am in my 40s and I am saving 2-3X more than I would if rates were 5%. Our cohort has gotten peanuts out of diversification and compound interest. Most of our money has been made at market peaks and to cling to it, we had to practice market timing
    I imagine that there are a lot of other households who are saving more than they probably should be.

    A few years ago, while having lunch with the management of one of Canada’s big banks, one leading PM asked why the banks did not have special bank accounts with no charges for kids so they could learn how to save. I had to chuckle because it showed how out of touch with reality the elite older generation really is and how the heck is his child supposed to understand banking when he gets a product that does not really exist for adults in the real world… I guess it’s to show the kids you can always manage to get some kind of freebie in life.

  12. sleeper

    I’m sorry the initial discussion of mortgage refinancing is a bit off.
    It should take into account the minimal uptick in refi –
    This is because in many locations the value of the real estate has fallen and the loan to value ratio precludes any refi activity.
    The “taper” is just for talk.

    1. Yves Smith Post author

      With all due respect, your comment makes no sense.

      75% to 80% of all new mortgage issuance (until rates went up a a result of the taper talk starting in May) was refis. It’t NOT minimal. It was a LARGE increase relative to pre-crisis levels (you only get refi booms when rates are low, and the last time was 2002-2003).

      Please consult data rather than speaking out of your personal beliefs.

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