How does ‘tapering’ affect markets?

The Federal Reserve has a communication problem.

QE3 and tapering

QE3 stands for the current quantitative easing policy of the Federal Reserve.

The Fed announced it would be purchasing $40 billion in mortgage-backed securities each month in September of 2012. Three months later, it expanded its commitment to include the purchase $45 billion of longer-term Treasury securities each month. In total, this policy of purchasing $85 billion in securities each month is called QE3.

When the Fed purchases securities, it pays the sellers of the securities. Sellers deposit their payment in banks, and the Fed credits the banks with deposits into their accounts at the Fed.

Under normal conditions, banks use the new deposits to increase loans and investments. The expansion in loans and investments tends to increase both the money supply and the pace of overall spending.

Even though the pace of spending has been weak, there is a widespread belief that the Fed’s commitment to purchase $85 billion a month has kept it from being even weaker. Hence, there is an equally widespread belief any cutback, or tapering, in Fed purchases would significantly weaken the economy. This is why stock prices collapse amid hints the Fed may begin to taper.

Monetary policy

What most financial market commentators don’t realize is there is no direct relationship between the Fed’s announced purchases of specific securities and its monetary policy.

From time to time, the Fed can and has offset the impact of its announced purchases of securities with other actions. Bernanke tried to explain how the announced purchases of securities really had nothing to do with its monetary policy, but few seemed to understand how it could be.

The confusion occurs, because the objective for QE3 wasn’t to provide additional monetary stimulus. Rather, the Fed’s objective was to alter investor confidence — to convince investors that longer-term interest rates would remain low.

Communication breakdown

The Fed believed its QE3 announcement could trick investors into believing long-term interest rates would remain low. What the Fed has actually done is to trick investors into believing the announced purchases of securities is the main source of monetary stimulus. As a result, the Fed now has a communication problem.

In its most recent meeting, Fed members had a lengthy debate, not over policy, but over communicating the Fed’s intention.

The Fed could end QE3 tomorrow, and it would have no impact on monetary policy.

However, since the Fed has convinced people its security purchases are the reason for easy money, any tapering would initially have a negative psychological impact on financial markets.

Hence, the Fed is stuck with a communication problem of their own making.

It appears that the only ones the Fed members tricked were themselves.  

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