Blog | Personal Finance

Tapering The Taper Talk

On September 18th, the Fed surprised the financial world by announcing that it would continue creating $85 billion a month even though it had led the market to believe that it would begin to “taper” its pace of fiat money creation from that date. The Fed’s announcement sheds a great deal of light on how they are managing the economy.

In one paragraph, here’s what you really need to know: The Fed is driving the economy by pushing up stock prices and home prices so that Americans will have more money to spend even though the median income is falling. It has the tools and, it appears, the determination to continue doing this. I believe the Fed’s goal is to push up stock prices by about 10% to 15% a year and to push up home prices by about 10% a year. It looks to me as though they have a good chance of succeeding at this for the next couple of years. That should be good news for investors.

Now, for the details. Here’s how it works. The Fed can control the interest rate on government bonds and mortgages by printing dollars and buying bonds until the bond prices rise and the bond yields fall to any level the Fed desires. The “desired level” is that level at which property prices and stock prices rise just enough to drive the economy (through creating a wealth effect that supports consumption), but not so much that a massive new bubble forms in the stock market and the property market. In the past, this would have been impossible because so much fiat money creation would have caused very high rates of inflation. It is possible now, however, at least for the time being, because Globalization is very deflationary and that is offsetting the inflationary pressures caused by fiat money creation.

Back in April, with the yield on the 10-year government bond below 1.7%, interest rates were too low and they were causing property and stock prices to climb too rapidly. To prevent a new bubble from forming, the Fed began suggesting it would soon start to taper its pace of bond purchases. The market immediately responded to that threat by selling bonds. That caused the yield on the 10-year bond to rise to 3.0% even before the Fed had actually done anything. The Fed did not want interest rates to rise that sharply. It feared that interest rates at that level would cause asset prices to stop rising – or maybe even fall. So, on September 18th, it pushed back its tapering timeframe. As a result, the 10-year bond yield fell back to 2.6%. It is clear that the Fed will continue printing $85 billion a month and buying bonds until the 10-year bond yield falls to its desired level (as defined above). The chances look good that the Fed is going to be able to get what it wants, i.e. higher asset prices. And that should keep alive the favorable investment environment that investors have benefited from since QE 3 was announced one year ago.

Now, before I come across as too Fed-friendly, let me repeat what I have written many times before. I believe the Fed played a leading role in creating this global economic crisis. Despite that, I also believe that their current policy of Quantitative Easing is now practically the only thing preventing this credit bubble from collapsing into a severe depression.

To clarify what I’m talking about, think of it like this: We are all in a hot air balloon that was created by the Fed, and we are floating miles above solid ground. We blame the Fed for getting us into the hot air balloon but, at the same time, we’re praying that the Fed will keep our balloon inflated – because the alternative involves crashing to our deaths.

There are those who say that the fall is inevitable, therefore the sooner we get it over with the better. That is a view that can only be supported by people who badly underestimate how far we have to plunge. Otherwise, it would be akin to asserting that since death is inevitable we should all commit suicide today.

A correct understanding of how vast the distance is between us and the ground demands that every effort be made to keep us afloat for absolutely as long as possible. My view is that if we can stay afloat long enough, we might just have time to build another means of transportation to take us off this balloon and safely where we want to go. That hope may prove to be merely a fantasy. Even so, even if the worst can’t be averted forever, I would still prefer to enjoy the view for a few more years before that time arrives. And, by the look of things, the Fed seems to feel the same way.

One other thing: I was in Kuala Lumpur last week and had an interesting conversation with Julian Ng of BFM radio. Please find the link to that interview below: