Looking Beyond the Tapering and Interest Rate Debate

To taper or not to taper? That is the big question facing the Federal Reserve. And as I have pointed out in Money and Markets’ columns, it’s the Fed’s actions that investors should be watching closely, because the U.S. central bank’s easy money policies have become the most powerful force affecting stock prices.

While most economists agree that continued tapering is inevitable, the Fed recognizes that it must be implemented in a manner that is least disruptive to the financial markets. Which means the debate is no longer about whether or not the Fed should begin tapering; instead it has shifted to how aggressive the Fed should be in executing its tapering plan.

Last week, Janet Yellen, in her first press conference since assuming the position of head of the Federal Reserve, explained the Fed’s decision to continue its tapering plan and set out the central bank’s new “forward guidance” about future interest rates. Her comments about QE came as no surprise. Yellen said that the Fed’s purchases will slow by $10 billion to $55 billion a month starting in April, with this gradual taper continuing until QE grinds to a halt, potentially as early as October. When QE ends, the Federal Reserve will own bonds worth around 22 percent of U.S. gross domestic product.

Last week, Fed chief Janet Yellen said that interest rate increases are a long way off.

With regard to interest rates, the Fed’s previous promise was to hold short-term rates below 0.25 percent until unemployment fell below 6.5 percent and inflation ticked up to approximately 2 percent. With the unemployment target coming within range, Yellen said future rate increases will be assessed using a range of economic data, with no single target. What’s more, Yellen went on to say that in her view, increases are a long way off.

That’s because the economic data is not as rosy as the QE cut suggests. For a start, there is little sign of inflation. Prices are rising at an annual rate of only 1.1 percent, well below the Federal Reserve’s target of 2 percent. Wages are hardly running away either, growing at about 2 percent. Home building has fallen sharply in recent months.

So the primary tapering concern is that without direct Federal Reserve intervention, rising interest rates could choke off the already fragile economic recovery.

But there is a more important reason to look through the current taper debate — one that is overlooked by many investors — and that has to do with the evolving role of the Federal Reserve in our economy. What sets our Federal Reserve apart from other central banks, most notably the European Central Bank, is its dual mandate originally established by Congress. Our Federal Reserve is charged with both maximizing employment and maximizing price stability. In the long run these are incompatible goals. In previous eras, the economic cycle determined which goal was emphasized — unemployment was the focus in recession and price stability in recovery.

In the current era these goals have become politicized, with the goal of employment gaining the clear upper hand. I do not see this changing in the foreseeable future. Like it or not, the Federal Reserve has become a proactive player in our economic system. Whether it is through direct purchases of government securities (which can easily be resumed at some future date) or some other form of direct or indirect stimulus, this is truly the “new normal.”

While Federal Reserve intervention five years ago arguably prevented a full-blown economic depression, the reasons behind the very modest global economic recovery are now largely beyond the Fed’s control. However, since the Federal Reserve has become such a powerful force in the economy, it will continue to seek the best levers for stimulating economic activity and increasing employment, even if there is no silver bullet.

While the stock market could decline as the tapering plan continues, the risk of a full-blown bear market remains relatively low. As long as Treasury bill rates remain around zero, and as long as the Federal Reserve is prepared to step in with additional stimulus if the economic recovery lags and unemployment rises, the Fed indeed “has the market’s back” and we remain in a sweet spot that supports high stock prices.

All in all, things are playing out exactly as I anticipated, with the Fed continuing to call all the shots. And that’s the way I expect it go for at least the next six months or so.

Best wishes,

Bill

Bill Hall is the editor of the Safe Money Report. He is a Certified Public Accountant (CPA), Chartered Financial Analyst (CFA) and Certified Financial Planner (CFP). Besides his editorial duties with Weiss Research, Bill is the managing director of Plimsoll Mark Capital, a firm that provides financial, tax and investment advice to wealthy families all over the world.