Why is the Fed ignoring a "differentiated taper"?

“I believe I am a sensible central banker and these are unusual times” - Janet Yellen, Testimony before Congress, February 11th, 2014.

In watching Janet Yellen's Testimony before Congress in February, and in reading Edward Luce's excellent commentary on the Fed in the FT (see here), it struck me that although Janet Yellen appears to be boxed in in terms of having an appropriate policy tool to get us out of the apparent slow growth US economy we now find ourselves in (see here for the latest Larry Summers opine about secular deflation), she is not.  And I'm not referring to "forward guidance" as the appropriate policy tool ( - a tool which I think has been ridiculous and based on flawed thinking).

As usual with these things, the answer is staring her right in the face.  Yes, the taper itself offers up the solution.  How?  Well in one of my previous blogs I outlined one exit strategy (see here) that I thought might be appropriate for the Fed to adopt. Although the Fed is currently reducing the purchases of both T Bills and mortgage backed securities (MBSs) at equal rates by $5bn each to $35bn of Treasuries and $30bn of MBSs (as most recently announced by the Fed on March 19th in the Fed's press release), this doesn't make too much sense to me in the current climate.

Why is this?  First, the Federal government Treasury interest rates really need to rise, and to be honest the Fed should be selling Treasuries right now, and certainly not buying anymore, given their recent (unwarranted) rally.

Second, the Federal government purchases were a way of stimulating the economy in two ways during the Federal government's economic stimulus a couple of years back - that is now not necessary as the stimulus is over and if anything the government deficit is rapidly shrinking. The chart below shows the US government budget deficit over the last decade, and we are now below the levels of deficits in terms of % of GDP that we experienced in the last major recessions, and more to the point, the trend line looks promising in terms of where we are going.

Third, with enough geopolitical risks in the rest of the world, I think it is safe to say that US Treasuries have enough demand support to weather a withdrawal of Fed support, so these purchases are really not optimal in terms of the objectives of monetary policy.

So I would argue that the Fed should heavily cut back on its purchases of US Treasuries while at the same time continuing to stimulate the housing market through purchases of MBSs.  I am calling this a "differentiated taper" as instead of just cutting purchases of both US Treasuries and MBSs, we can lower the overall amount of purchases while at the same time having a differential effect on the markets for each type of security.

Why is the concept of a "differentiated taper" important?  The reason why is that purchases of MBSs have an indirect impact on the housing market, as it lowers mortgage rates, thereby stimulating the construction of new housing.  Specifically, it should stimulate the employment of both blue and white collar workers in the construction industry, as more housing construction equals more hiring of architects, builders, contractors and subcontractors. What does purchases of government Treasury securities get us?  Lower borrowing rates for government, that's for sure, but not much else. Certainly there is no stimulus to the job market there right now as the government is cutting back on spending to move towards a balanced budget.

So if I were working at the Fed right now I would at the least be recommending a "differential taper" with an increase in purchases of MBSs of around $10bn, and a reduction in purchases of Treasuries by the Fed of around $20bn. This still balances out to a "taper" of $10bn, but it is differentiated, by stimulating the housing market, while allowing a longer term correction to the yield curve, a correction in my view that is now sorely needed.  

2014 and the Business Cycle: Continuing Recovery and Another Year of Opportunity in the Stockmarkets?

First off, Happy New Year to all my Econoblog readers.  If you want a review of 2013, rather than rabbittng on here, I thought I would just point you to a wonderful article in The Atlantic on the Most Important Economic Trends in 2013 which you can find here. In this Econoblog I want to look ahead to what might happen in 2014, as some eminent economists have been doing at the most recent American Economics Association meeting..

As the business cycle is now in heading into the later part of the cycle, with the danger of recession and deflation receding, most countries will experience accelerating growth this year.  Although markets are jittery about the Fed’s signal to taper monetary policy, this is long overdue in my view, and will only have a marginal effect on economic growth in the US and other developing countries.  The economic process of re-invigorating the economy through stimulus has now done its magic, and in North America, Europe and now Japan, the growth dynamic has started to take on a life of its own, so that the agents of stimulus can now withdraw their assistance as a catalyst for economic growth.

So there are 2 further issues here – first, how will economic growth be distributed among the developed countries, and second, given what is going on in the developed world, what are the prospects for the developing countries.

Although the consensus is almost uniformally positive for the US for 2014, it is still probably the most uncertain country in the developing world to forecast for 2014, as there are so many factors that might impinge upon economic growth rates. The most notable are fiscal matters and the political problems in Congress, the ongoing taper, and when the actual tightening of monetary policy will begin, how movements in long term interest rates will impact the housing market and also lastly, how the dollar will behave during the upcoming year.  If the current truce in Congress yields more bi-partisan consensus on how to move ahead in other contentious areas (such as immigration reform, for example), then this could boost growth as confidence is at least partially restored in the US political process.  Given a brighter fiscal outlook, this would mean that Fed purchases of government bonds could be slowed much more quickly than Mortgage backed securities (MBS), which would allow a residual boost to the housing market rather than propping up a shaky Federal government credit rating. Longer term interest rates are key in determining the course of mortgage rates, and if the Fed keeps these low enough for long enough, the housing market could really boom, setting off a real investment boom in the rest of the economy.  Of course everything could go the other way as well, leading to a further downgrade in the credit rating of US debt, a Fed that ends up having to reverse the taper because of a sagging labor market, and a housing market that experiences a bubble because of prices rising too far too fast. 

In my view, the history of economic cycles points to a positive future though for the US, and although some of the shorter term cyclical effects will be present, the dominant longer term cyclical features will push the US forward without any major internal economic dislocations, leading to another good year for both the housing and stock markets.  This of course implies another bad year for the bond market with yields moving upwards to levels more typically associated with this stage of the business cycle.

But perhaps the best opportunities in North America lie not in the US, but in Canada.  The Canadian market has been extremely stable through the recent turmoil and the Canadian stockmarket has really not shown much of a return compared with its US counterpart, which in my opinion is almost counter-intuitive, but is probably based on the perception that Canada has an economy based much more on commodities than the US does.  Nevertheless, in my view the Canadian market still has much less downside risk that the US market does, and much more upside.

Japan and the EU have less potential for growth as demographic factors restrain both entities. The fact that Abenomics seems to continue to deliver the goods will push Japanese markets higher and lead to the deflationary threat receding.  In the EU the resurgence of the northern member states will continue and the Southern member states will start to emerge from the difficult deflationary period they have been in. 

The biggest risks, but also the biggest rewards in 2014, lie in the developing world.  Developing country markets were rocked by the initial announcement of a taper, but now that the ongoing taper and then tightening has been priced into the markets the real effects on the developing markets should be apparent. As monetary tightening occurs in the US, so the liquidity glut will start to disappear, putting some pressure on developing countries.  Now the big question is, how big will the impact be on countries like the BRICSA countries.  Brazil should be cushioned by the massive infrastructure spending going on there for the Olympics and the World Cup, while Russia really is not dependent on the stimulus as it is natural resource prices that really drive the Russian market.  South Africa is certainly not a large holder of US bonds so the taper will likely have minimal effects on that country.  No, the biggest risk is in both China and India, where both countries have a significant interest in holdings of US debt. 

Given the negative announcement effect of the Fed’s taper, I believe that possibly the best performing markets will be in Canada, parts of Latin America, Africa and parts of Europe next year. Now I have put my neck on the line, let's see what happens!