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Behind the Fed's Taper Tactics

Jason Stipp
Robert Johnson, CFA

Jason Stipp: I'm Jason Stipp for Morningstar. The Federal Reserve surprised everyone on Wednesday by announcing that they would continue their bond purchases, $85 billion a month of bond purchases, whereas most people expected them to start tapering. The market liked the news, but what was really behind the decision? Here to offer his insights is Morningstar's Bob Johnson, our director of economic analysis.

Thanks for joining me Bob.

Bob Johnson: Great to be here.

Stipp: What exactly caused the Fed to make this decision? Almost everyone thought they would at least modestly start to taper those bond purchases, and they said, not so fast, we're not going to do it yet.

Johnson: Yes. The key thing the Fed said is the broad contours of things [were similar to how] they were in June, when they first thought about this, but they also said that they needed some more confirming data to really come to that conclusion. There were number of things on their mind that caused them I think to back away.

One of them is certainly, that they mentioned again and again, fiscal policy, that is the money that Congress agrees to spend every year. [Fed chairman Ben Bernanke] said that those policies have been remarkably tight. And right now, we have not got a budget for 2014 yet, and that we're coming up on the deadline. There are threats to shut down the government and some real acrimonious debates right now going on. And I think they were little fearful that they didn't want that going on, the threat of government shutdown coming on the same day that they physically stop buying the bonds.

Stipp: Yes, it's essentially a double whammy, potentially if we have a real government shutdown or a stoppage in the fiscal situation because of the wrangling.

Johnson: Exactly. They've always felt a little bit that their loose monetary policy was based on how tight the fiscal policy, that is the government spending. Those are two arms of improving an economy, as you have easy monetary policies and you have easy fiscal policies. Fiscal was unbelievably tight. We talked a little bit in last week's column. We went from a $1.1 billion deficit to a $600 million estimated of a budget deficit in one year. We've probably never seen a deficit come down that much in one year. And that's a lot of pain to absorb.

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Stipp: It's quite possible that Fed wanted to get past some of these debates that are going to be happening in Congress this fall before they made anything definitive on tapering. Another reason is that the mortgage rates really ticked up when the Fed just started talking about tapering and maybe they went up a little bit faster than the Fed thought they would.

Johnson: Yes, I think they were surprised a little about how much they went up. I think Bernanke tried to say [that the Fed will] take what comes and whatever. But I think they were a little surprised at how much the mortgage rates had gone up, and indeed they did affect the housing industry. We had some data Wednesday morning that further indicated that the housing market has slumped a little bit in here. I mean it's not falling apart, but it's certainly not as robust as it was. Certainly, I think that probably weighed on their decisions little bit that housing has been slowing here for the last couple of months a little bit.

Stipp: And back in May when the idea of tapering was first put on the table, emerging markets were also affected. Do you think what happened in emerging markets following the first talk of the taper had anything to do with this later decision not to go ahead with it right now?

Johnson: I think Bernanke was pretty clear that it was not based on emerging markets. I thought maybe some of what was going on in emerging markets had to be working on the back of his head because some of the things in India and some other countries are getting really pretty nasty. I thought maybe that was weighing on his decision. But he was very clear on that, clearer than I would have imagined. He said you know what, the best thing for an emerging-markets country right now is a strong United States because they ship so many products to the U.S. and that the best way that he can help emerging markets is by having a strong U.S. economy, despite whatever rate changes might do to those emerging-markets economies indirectly.

Stipp: When the idea that rates would start to go up here in the U.S. was put on the table, some money left the emerging markets and came back to the U.S. because they could get a relatively better rate here?

Johnson: Absolutely. For some of those countries to raise interest rates, to try to keep money in the country, that slows economic growth. So that was certainly not a good thing for emerging markets to face at all. And on top of it, a lot of what emerging markets buy is oil, and if they buy oil in dollars and their currencies are getting weaker by the day, record lows as a matter of fact, that also puts up inflation and also makes for political unrest in emerging-markets economies. The policies in my mind were beginning to hurt emerging markets, like it or not.

Stipp: Back here in the U.S., the Fed did lower their economic forecasts. Obviously things aren’t quite as good as maybe they thought they were before. My question to you is, Bob, the economy looks like it's maybe a little bit worse than they thought. The market's happy about this news of not tapering. How do we interpret the market's reaction here?

Johnson: I think [the market was] just relieved at the thought of continued free money, I am afraid. I really like to think that there are more fundamentals behind it than that. I think they really like the idea of the cheap money, and the surprise nature of it was certainly good. But as you point out, I think some of it in the next few days, people may say, "Maybe that's not so good, that the economy is not as strong as we thought it's going to be."

Stipp: Here is another question, Bob. Some people are wondering if the bond-buying program has even really worked that much, especially if the market is surprised by this news and happy about it today, they might say the economy is weak. That's the implication, anyway, and they might start to question whether the bond buying has really had an effect. Do you think it has?

Johnson: First of all there is one level where people say the economy is growing no faster than it was when some of this started, so it hasn't been a factor. So there is pointing to evidence of that. And then there are other real formal studies, including one by the San Francisco Fed, which says maybe [the bond-buying] added 1/10 or 2/10 to growth.

I was shocked. I thought there might have be a number of Fed governors that would vote to begin tapering the bond purchases because they just philosophically believed [the bond purchasing] wasn’t worth the risk and really wasn’t adding that much.

Bernanke came out swinging on that one Wednesday afternoon, absolutely swinging. He cited the Congressional Budget Office and cited all the really tight fiscal policy that had been going on, the huge deficit reduction that we saw happen in just one year. He said that the Congressional Budget Office, an independent agency, said that gross domestic product will be reduced by 1.0% to 1.5% by these tight fiscal policies and [the economy would] lose hundreds of thousands of jobs, and I quote from the Congressional Budget Office report. And so Bernanke's saying it's great that we were able to hold at a 2% GDP growth rate and actually add jobs instead of losing jobs. It's a real testament to how well [the bond-buying program] had done. And he said the bond buying can't do everything, and look at what's happened to autos and housing and the two markets that we can directly impact and that it has helped.

He really took, I thought, a pretty strong swing at it. Not everybody else on the Federal Open Market Committee, I think, necessarily agrees with him, but he is the leader right now, at least for another few months and that's important.

Stipp: If Bernanke is right and the bond buying is having an effect, what do you expect will happen with interest rates, now that they have decided not to start tapering?

Johnson: I think longer term, the broad measure is that interest rates really do need to be tracking the rate of inflation, and within the rate of inflation of about, pick a number, 1.5% or so and usually add about a 2.0%-2.5% premium--you're at kind of a 3.0%-3.5% 10-year bond.

Now, everybody knows that tapering is somewhere down the road here. It's not like it's indefinite anymore, and I think that rates will never go back to the 1.6% they were before they have started whispering about the tapering program. I think we may get some short-term relief on interest rates, and it might be good for the economy to get back a little bit. Everybody might say, "I missed the last round; I'm not missing them this time around." It might just be the little jar that the economy needs to get off of dead center here.

Stipp: What are the risks of continuing to do the bond buying at this point?

Johnson: I'm worried about that. Bernanke kind of pooh-poohed it a little in the conference call. But I worry the Fed bond buying is going to be a greater and greater percentage of the whole bond market. How they'll ever kind of unwind this mess--they're hoping to keep it on their balance sheet forever and kind of use different tools is what he implied. I don't exactly understand what all of those are. The big risk is that it goes on forever and that the free-money speculation that was going on may heat up again if it looks like the Fed is never going to really stop buying these bonds.

Stipp: A surprise decision from the Fed on Wednesday, but solid analysis from you Bob as always. Thanks for joining me.

Johnson: Thank you.

Stipp: From Morningstar, I'm Jason Stipp. Thanks for watching.