THE TAPER: Recalibrating Liquidity
The “Taper” has begun. It’s important to understand why.
On December 18th, the Fed announced that it will begin to taper the amount of fiat money it creates each month from $85 billion to $75 billion starting in January. Chairman Bernanke also indicated that the Fed is likely to continue reducing the monthly amount of money it creates by $10 billion at each future FOMC meeting - so long as the economy performs in line with his current expectations. That would bring QE3 to an end by December 2014.
The press has attributed the Fed’s decision to taper to an improvement in the outlook for the economy. I don’t believe that is the correct explanation. The recovery is still too weak and uncertain to justify tapering on those grounds. In my opinion, the real reason is to prevent excess liquidity from creating a new, destabilizing asset price bubble in stocks and property.
During 2013, the Fed has injected just over $1 trillion of liquidity into the financial markets through QE. Over the same period, the government has sucked nearly $700 billion of liquidity out of the markets by borrowing to finance its budget deficit. That left $300 billion of excess liquidity that was invested into other asset classes, most notably stocks and property. On top of that, a further $400 billion of liquidity entered the United States from abroad as a surplus on the country’s financial and capital accounts. (See Macro Watch Fourth Quarter 2013 for a detailed explanation.) This excess liquidty explains why the S & P 500 Index and home prices are up 25% and 13%, respectively, this year.
In 2014, the government’s budget deficit is expected to be $200 billion smaller than in 2013. That means the government will borrow $200 billion less. Therefore, if the Fed continued pumping $1 trillion of liquidity into the financial markets, it is probable that stock prices and property prices would move up even more next year than they did this year. That would once again inflate both the stock market and the property market into unsustainable bubbles.
The Fed needs asset prices to inflate in order to create a “Wealth Effect” to drive the economy. However, it does not want an out-of-control asset price boom because it knows a bust would inevitably follow. The purpose of the taper is to rein in excess liquidity before it is too late.
Despite the taper, liquidity is likely to remain excessive during the first half of 2014; and that should continue to create a favorable environment for the stock market and the property market.
Based on the taper schedule that Bernanke outlined during his post-FOMC press conference, it appears that the Fed will still create roughly $350 billion of new liquidity during the first half of 2014. That will be more than enough to finance the government’s budget deficit during that period. The deficit for the full year is expected to be about $600 billion; but, since people pay taxes in April, the deficit tends to be lower during the first half of the year than during the second half. Therefore, the government could borrow as little as $200 billion during the first half of 2014. That would leave ample excess liquidity to push stocks and property higher for several more months.
The liquidity environment could become considerably more challenging during the second half of the year. That is still some time away, however. By then, the Fed may have backtracked once again. After all, they have stopped QE twice before, only to relaunch it when the economy turned down again. If interest rates start to move up or if the economy once again begins to weaken, the Fed could put taper on hold or even reaccelerate its pace of fiat money creation back to $85 billion a month – or even more!
Here’s the bottom line. Despite some encouraging economic data recently, the recovery is still fragile; and most of the economic strength that is coming through is the direct result of the wealth effect brought about by QE and asset price inflation. It is crucial to understand that the Fed is driving the economy by pushing up asset prices. The Taper is simply a recalibration to ensure that asset prices continue to rise at a sustainable pace rather than in a crack-up boom.
In the next issue of Macro Watch, which will be uploaded in early January, I will show that the recent improvement in the economy is due primarily to the surge in household sector Net Worth brought about by QE. I’ll also evaluate the outlook for liquidity using the Liquidity Gauge framework introduced last time.
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