The Taper Heard Round the World

The Taper Heard Round the World

The stock market hit a new high and the dollar climbed against a number of foreign currencies, all because Federal Reserve Chief Ben Bernanke signaled a change to its massive bond buying  practice. Beginning in January, the FOMC will only add $75 billion in bonds to its holdings per month instead of $85 billion.

The Federal Reserve’s holdings of long-term securities are massive, and will continue to grow, just slightly slower than they had been growing. The significance of the modest change, however, has not been lost. It seems to signal a confidence in the recovery that had been lacking up to now. And the markets have responded.

If (and when) warranted, the Committee will continue to cut the amount of its monthly purchases. The course will not change regardless of who is at the helm of the Fed. Bernanke is set to retire at the end of January and while not yet confirmed, the White House nominee to replace him, Janet Yellen, will proceed in the same manner. Eventually, perhaps by the end of 2014, there will be no more purchases.

The question is, what does the Fed see differently now than it did three months ago? Unemployment is still high, but it has dropped to 7%, a number it has not seen in five years. Industrial output in November was up to prerecession levels for the first time. Those two numbers factored largely in the FOMC decision but we would be willing to bet there was a third factor: over time the efficacy of a program like this diminishes. It’s possible that the value derived from purchasing bonds just isn’t there anymore.

We don’t want to minimize the effectiveness of what the Fed has done. When we compare our recovery to that of other areas (like the E.U.) there is no question that the U.S. Central Bank was on the ball.

In June 2009, the unemployment rate in the U.S. was 9.5%. It was a comparable 9.4% in the Eurozone. In the four and a half years since, it has dropped to 7% in the U.S. while surpassing 12% in Europe. The Fed is certainly tracking better the European Central Bank.

Inflation, the flip side of the Fed’s dual mandate, still “stubbornly” remains below the target of 2%. But it is much better than the annual inflation rate in Europe, which in November was just 0.9%.

Whether we like it or not, even with the risk of creating a new financial bubble, the Federal Reserve’s bond purchases have played a major role in these results. Unemployment is projected to hit 6½% by the end of 2014. Assuming inflation doesn’t drop, the Committee will finish  tapering and finally stop growing its balance sheet.

Actual tightening is another story. The Fed Funds rate is expected to remain at near zero as long as inflation is below 2%. That may not be until 2016. That’s bad news for CD investors.