Can The Fed Taper?

The Taper Tapir

Back in June, I correctly noted that it was severely unlikely that the Federal Reserve would taper its asset buying programs in September. I based this projection on the macroeconomic indicators on which the Federal Reserve bases its decisions — unemployment, and inflation. The Federal Reserve has a mandate from Congress to delivery a monetary policy that results in full employment, and low and stable inflation. With consumer price inflation significantly below the Fed’s self-imposed 2% goal, and with the rate of unemployment relatively high — currently well over 7% — I saw very little chance of the Fed effectively tightening by reducing his asset purchases.

There exists another school of thought that also correctly noted that the Fed would not taper. This other school, however, believes that the Fed cannot ever taper and that the Fed will destroy the dollar before it ceases its monetary activism. This view is summarised by the Misesian economist Pater Tanebrarum:

While it is true that the liquidation of malinvested capital would resume if the monetary heroin doses were to be reduced, the only alternative is to try to engender an ‘eternal boom’ by printing ever more money. This can only lead to an even worse ultimate outcome, in the very worst case a crack-up boom that destroys the entire monetary system.

So the Misesian view appears to be that the Fed won’t stop buying because doing so would result in a mass liquidation, and so the Fed will print all the way to hyperinflation.

Since talk of a taper began, rates certainly spiked as the market began to price in a taper. How far would an actual taper have pushed rates up? Well, it’s hard to say. But given that banks now have massive capital buffers in the form of excess reserves — as well as a guaranteed lender-of-last-resort resource at the Fed — it is hard to believe that an end to quantitative easing now would push us back into the depths of post-Lehman liquidation. Certainly, in the year preceding the announcement of QE Infinity — when unemployment was higher, and bank balance sheets frailer — there was no such fall back into liquidation. What a taper certainly would have amounted to is a relative tightening in monetary policy at a time when inflation is relatively low (sorry Shadowstats) and when unemployment is still relatively and stickily high. Whether or not we believe that monetary policy is effective in bringing down unemployment or igniting inflation, it is very clear that doing such a thing would be completely inconsistent with the Federal Reserve’s mandate and stated goals.

Generally, I find monetary policy as a means to control unemployment as rather Rube Goldberg-ish. Unemployment is much easier reduced through direct spending rather than trusting in the animal spirits of a depressed market to deliver such a thing, especially in the context of widespread deleveraging. But that does not mean that the Fed can never tighten again. While the depression ploughs on, the Fed will continue with or expand its current monetary policy measures. Whether or not these are effective, as Keynes noted, in the long run when the storm is over the ocean is flat. If by some luck — a technology shock, perhaps — there was an ignition of stronger growth, and unemployment began to fall significantly, the Fed would not just be able to tighten, it would have to to quell incipient inflationary pressure. Without luck and while the recovery remains feeble, it is true that it is hard to see the Fed tightening any time soon. Janet Yellen certainly believes that the Fed can do more to fight unemployment. This could certainly mean an increase in monetary activism. If she succeeds and the recovery strengthens and unemployment moves significantly downward, then Yellen will come under pressure to tighten sooner. 

In the current depressionary environment, the hyperinflation that the Misesians yearn for and see the Fed pushing toward is incredibly unlikely. The deflationary forces in the economy are stunningly huge. Huge quantities of pseudo-money were created in the shadow banking system before 2008, which are now being extinguished. The Fed would have had to double its monetary stimulus simply to push the money supply up to its long-term trend line. Wage growth throughout the economy is very stagnant, and the flow of cheap consumer goods from the East continues. So Yellen has the scope to expand without fearing inflationary pressure. The main concerns for inflation in my view are entirely non-monetary — geopolitical shocks, and energy shocks. Yet with ongoing deleveraging, any such inflationary shocks may actually prove helpful by decreasing the real burden of the nominal debt. Tightening or tapering in response to such shocks would be quite futile.

Sooner or later, the Fed will feel that the unemployment picture has significantly improved. That could be at 5% or even 6% so long as the job creation rate is strongly growing. At that point — perhaps by 2015  — tapering can begin. Tapering may slow the recovery to some extent not least through expectations. And that may be a good thing, guarding against the outgrowth of bubbles.

Yet if another shock pushes unemployment up much further, then tapering will be off the table for a long time. Although Yellen will surely try, with the Fed already highly extended under such circumstances, the only effective option left for job creation will be fiscal policy.

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35 thoughts on “Can The Fed Taper?

  1. John, if I understand gold-standard theory correctly, a basic premise is that it contains a mechanism which inherently regulates and balances trade. Gold outflows from a nation due to relative high cost, would automatically force a reduction in cost, keeping business competitive in a global sense. Fiat monetary systems on the other hand, have eliminated the “mechanism”, allowing trade to “unbalance” and persist in this state up to the present. Thus Western nations have high unemployment due to a persistent high cost of living. The cost of living in the US started ramping in the early 70s and peaked in our day. Industry correspondingly migrated.

    Business in the US will not develop because our cost of living is too high in a global respect….and our cost of living will not adjust down due to the FED’s continuing fiat monetary actions. The US can be viewed as a person being strangled to death, the choke being provided by the FED keeping costs high.

    You ask the question “Can the Fed taper?” Should we not also ask “How long can we refuse to lower our cost of living in a global economy?”

    • The gold standard is just an arbitrary limit on the size of the monetary base. In practice, gold-based economies very often were still credit-driven economies and so not very different to the modern fiat systems. Even in times of crisis, there were still lenders of last resorts and bailouts (see 1907). It provided no such barrier to trade imbalances. The international monetary system that broke down due to massive trade imbalances prior to WW1 was the classical gold standard.

      However you’re not THAT far from the truth in terms of the causes of Western unemployment. Look at this graph:

      Basically the Western middle class has been completely shafted by globalisation. Capital is mobile — and can seek out cheap labour worldwide — but labour is not mobile. This tide of globalisation has depressed Western wages for a long time. This isn’t due to the Fed (why do you capitalise? It’s not an acronym…), it’s due to national boundaries that prevent labour from being fully mobile. Certainly, this isn’t strangling the US to death — and it’s a trend that may soon reverse as automation becomes cheaper even than Asian or African labour, lifting all boats on a rising tide — but it’s pretty ugly for the Western and American middle class.

      • Good points. By “strangled to death”, I meant what is actually happening, but not actually being felt…yet. Sort of like Wiley Coyote running off a cliff—he never immediately felt the effects of gravity. The Fed is providing the current cost-correction delay by all its interventions. If they had not intervened in housing, housing would already be cheap—one step necessary for business to be able to pay lower wages. But as one whose business is automation, I’m not sure I share your optimism. Better to share productive opportunity than cheap products.

  2. The idea that tapering, and even exiting QE in a smooth, controlled manner rests on the idea that a ‘virtuous cycle’ can be created, as policy easing leads to growth, which feeds on itself in some vague, often never explained manner. In reality it’s never played out like that, mainly because the ‘recovery’ is entirely dependent on a continued, sustained easing of financial conditions.

    The events following the beginning of taper talk in May bear out the Misesian position. The Fed mentioned it would taper, and immediately the process of tightening in financial conditions began, particularly in the mortgage market. The ‘recovery’ as it stands is largely on the back of a housing resurgence, and the implication of less money being pumped into the system to bid up housing threatened that recovery, and in turn the recovery as a whole. Bernanke explicitly stated this at the press conference explaining why they didn’t taper.

    This is going to be the case going forward. Every time the Fed attempts to taper, the fact that there is less money to bid up prices means that the prices will rise at a slower rate, if at all. This is going to culminate in a slowdown at the very least, if not a crash. Not only can the Fed never taper, but even sitting flat will do the recovery in. They will have to INCREASE the pace of QE with each successive round. Of course the ability to increase the pace of money printing in perpetuity is limited. Therein lies the accuracy of that Mises quote about there being no escape from a collapse brought about by credit expansion.

    I flesh these points out a bit more here: http://thedismaloperator.wordpress.com/2013/09/17/celebrating-at-halftime/

    Also, I find it odd that you say that Austrians ‘yearn’ for hyperinflation. This is not even remotely true. Us Austrians yearn for sustainable growth above anything else. But regarding hyperinflation, the fact that it hasn’t happened yet isn’t indicative of the Austrians being ‘wrong.’ Quite frankly, the whole story hasn’t played out yet. Remember that on embarking on the monetary easing programs, we were told that it would be ‘temporary’ and the tools to exit once growth kicked in were there. They clearly haven’t exited, or even begun, so we’re very much bang in the middle of experiment.

    On that, Hayek wrote that essentially if the goal is to replenish capital and investment WITHOUT allowing the necessary savings and deflation that it requires, then the easing has to be carried to such a point that prices will rise. In other words, as long as there is ‘low inflation,’ the Fed will keep banging on the proverbial ketchup bottle, until finally the contents splatter everywhere. We will most likely see $100billion/month before $70billion. And in the odd chance they go to $70 billion first, the next move will be north again.

    • The idea that tapering, and even exiting QE in a smooth, controlled manner rests on the idea that a ‘virtuous cycle’ can be created, as policy easing leads to growth, which feeds on itself in some vague, often never explained manner.

      That necessary virtuous cycle can be endogenous, from a technology shock, not just from policy. Seeing as I am a policy sceptic, I tend to believe if a virtuous cycle comes it will be endogenous.

      The events following the beginning of taper talk in May bear out the Misesian position. The Fed mentioned it would taper, and immediately the process of tightening in financial conditions began, particularly in the mortgage market. The ‘recovery’ as it stands is largely on the back of a housing resurgence, and the implication of less money being pumped into the system to bid up housing threatened that recovery, and in turn the recovery as a whole. Bernanke explicitly stated this at the press conference explaining why they didn’t taper.

      This suggests the economy is pretty weak. Tapering would hurt the economy significantly. It says nothing about whether the economy is eventually going toward hyperinflation

      This is going to be the case going forward. Every time the Fed attempts to taper, the fact that there is less money to bid up prices means that the prices will rise at a slower rate, if at all. This is going to culminate in a slowdown at the very least, if not a crash. Not only can the Fed never taper, but even sitting flat will do the recovery in. They will have to INCREASE the pace of QE with each successive round. Of course the ability to increase the pace of money printing in perpetuity is limited. Therein lies the accuracy of that Mises quote about there being no escape from a collapse brought about by credit expansion.

      There’s no evidence to really support this. If we do get into a virtuous cycle — and again, that can have absolutely nothing to do with policy but everything to do with technology, energy, an end to deleveraging etc — then the Fed can taper without any pain. And as Japan shows, even if we don’t get out of the trap for 20+ years, hyperinflation doesn’t kick in. At the zero bound there just isn’t what the Friedmanites would call velocity. This is probably due to continued deleveraging, thrift and employment slack.

      Also, I find it odd that you say that Austrians ‘yearn’ for hyperinflation. This is not even remotely true. Us Austrians yearn for sustainable growth above anything else. But regarding hyperinflation, the fact that it hasn’t happened yet isn’t indicative of the Austrians being ‘wrong.’ Quite frankly, the whole story hasn’t played out yet. Remember that on embarking on the monetary easing programs, we were told that it would be ‘temporary’ and the tools to exit once growth kicked in were there. They clearly haven’t exited, or even begun, so we’re very much bang in the middle of experiment.

      I do think Misesians yearn for hyperinflation and collapse, because it would validate their views (as much as they might derp about not caring about empirics) regarding the fundamental unsustainability of the present system. The monetary easing programs were always described as unconventional monetary policy to tackle specific challenges, specifically deflation and unemployment. Given that mass unemployment is still widespread, it is explicable that there has been no exit yet, and that in fact by the Fed’s own criteria it would be absurd to exit now. Of course, as a monetary sceptic, I am not entirely surprised monetary policy hasn’t really defeated unemployment (or even entirely reversed the deflationary trends in the economy) but that’s not the point.

      On that, Hayek wrote that essentially if the goal is to replenish capital and investment WITHOUT allowing the necessary savings and deflation that it requires, then the easing has to be carried to such a point that prices will rise. In other words, as long as there is ‘low inflation,’ the Fed will keep banging on the proverbial ketchup bottle, until finally the contents splatter everywhere. We will most likely see $100billion/month before $70billion. And in the odd chance they go to $70 billion first, the next move will be north again.

      I do think an increased level of QE is possible or even probable under Yellen. This would not vindicate the Misesian view at all. Yellen is increasing it to fight unemployment. If it actually works and unemployment is reduced, then tapering becomes inevitable, and if unemployment is low and growth is strong, tapering will be successful. If it doesn’t work, we face more years of Japan-style stagnation. No taper, but no hyperinflation either.

      • A massive leap forward in technology advancements would be, with respect to prices, deflationary. By taking the basic stance that deflationary pressures should be fought, you’re necessarily seeking to reverse the effects of human progress. So I see a disconnect in your reasoning. On one hand you’re saying you’re a policy skeptic, looking for more ‘real’ factors like technology to save us, yet the effects of technology saving would ultimately be ‘detrimental’ deflation, which policy can defend against.

        As for my point that tapering is going to lead to the next crisis, and your response that the taper can happen seamlessly if we run into a virtuous cycle: As I wrote before, we saw a mini example of this with the bounce back in housing. The low mortgage rates made home prices ‘affordable’ such that there was a bid. I’ll leave aside the fact that this bid has almost come entirely from Wall St., and that Joe Sixpack still isn’t in a position to afford a home. If the Fed tapers, mortgage rates rise, and suddenly there is less demand for homes. Again, this is what was happening in the short span of time between Taper Talk and the Sept Fed meeting. Had that continued, the Wall St firms which had loaded up on single family homes would have found that they massively overpaid for those homes, and needing to cut losses and/or preserve small gains, they’d have to dump en masse, adding to the pressure in the market. Housing, and the economic recovery go into the toilet again. That’s why the Fed did not taper.

        For home prices to remain bid, there has to be a continued influx of credit. Without it, nobody can afford homes at the price level they’re at. It’s that simple. There’s actually not much evidence for the ‘virtuous cycle’ theory and countercyclical policy, historically speaking. Every instance of the Fed hiking rates over the last 40 years or so has resulted in recession – not because hiking rates is inherently bad, but because the economic paradigm at the time was built on lower rates, such that a higher rate caused problems. And this lower rate was the result of mitigating a prior recession. The fact that we’re in extraordinary times with extraordinary measures doesn’t really change that basic dynamic in my view.

        The validation of Austrian views isn’t contingent on hyperinflation. It’s contingent upon what happens when the Fed exits. If they exit cleanly, the Austrians are wrong. If this ends with a deflationary crash OR hyperinflation, the Austrians are right. Recall the Mises quote about credit expansion booms and how they end. He said it was either a voluntary collapse, or a currency destruction. That’s the Austrian view. The opposition view is the idea that the Fed can mitigate and get out with no problems. What I find interesting is that the opposition view tends to declare the Fed’s actions a success at the mere existence of recovery. If anything bad happens later, it’s the result of some ‘shock,’ That myopia was at the heart of the Celebrating at Halftime piece I linked before.

        Over the last 40 years, and in particular starting with the Greenspan Fed years, we have had a few pronounced ‘voluntary collapses’ in the Misesian sense (the Fed raising rates). Maybe we’ll have to go through more. But the subsequent easing which is always done to mitigate the recessions has its limits. Nobody knows what those are, since they are tied to human psychology. But a limit does exist, and the fact we haven’t crossed it yet doesn’t render the Austrian view to be incorrect. As I said we might have another deflationary collapse. But if the response is always easing,(at ever greater amounts to boot), we will surely cross that line.

        • A massive leap forward in technology advancements would be, with respect to prices, deflationary. By taking the basic stance that deflationary pressures should be fought, you’re necessarily seeking to reverse the effects of human progress. So I see a disconnect in your reasoning. On one hand you’re saying you’re a policy skeptic, looking for more ‘real’ factors like technology to save us, yet the effects of technology saving would ultimately be ‘detrimental’ deflation, which policy can defend against.

          The effects of technology extend far beyond prices. Far more important than price trajectory is surely economic activity level, disposable income and expectations.

          It is not true that I am a great proponent of fighting deflation. I just think it’s completely inevitable in our system which has huge quantities of interconnective assets. Deflation can turn such a system extremely toxic extremely quickly as we saw in 2008. Given that most people’s pensions are denominated in debt-based assets there is absolutely no way that they will be allowed to collapse. Whatever I think of this, it’s just a fact of life in the system that exists today.

          Had that continued, the Wall St firms which had loaded up on single family homes would have found that they massively overpaid for those homes, and needing to cut losses and/or preserve small gains, they’d have to dump en masse, adding to the pressure in the market. Housing, and the economic recovery go into the toilet again. That’s why the Fed did not taper.

          For home prices to remain bid, there has to be a continued influx of credit. Without it, nobody can afford homes at the price level they’re at. It’s that simple. There’s actually not much evidence for the ‘virtuous cycle’ theory and countercyclical policy, historically speaking.

          Most of this is actually expectations oriented. Even if the Fed tapers significantly there is huge liquidity around already. In fact, as most liquidity is created endogenously by the market, Fed activism has probably more of a psychological effect than a real one. If the market has a head of steam and is genuinely excited going forward, tapering will make little difference. Of course, this requires a virtuous cycle. But the way markets and human psychology work, we will probably get one sooner or (as in Japan’s case) later.

          The validation of Austrian views isn’t contingent on hyperinflation. It’s contingent upon what happens when the Fed exits. If they exit cleanly, the Austrians are wrong. If this ends with a deflationary crash OR hyperinflation, the Austrians are right. Recall the Mises quote about credit expansion booms and how they end. He said it was either a voluntary collapse, or a currency destruction. That’s the Austrian view.

          Sure. And I’m starting to think it’s exceedingly unlikely to end in either. The deleveraging trap is beatable. It was beaten after 1929 (eventually). Maybe we won’t truly get there ’til the 2030s and maybe there will be some nasty intervening events (hopefully not a world war again!) but eventually the deleveraging cycle ends, and a virtuous cycle breaks out. This time around, I am excited about a lot of technologies and their potential to ignite optimistic expectations and a virtuous cycle.

  3. The flaw/missed point that Austrian economists make is they assume Banks ALONE are necessary and debt ALONE is monetary reality. The money system is digital in nature and so debt (a minus of money) can be cancelled by monetary Grace (a plus of money) which is exactly what is needed immediately in the form of a jubilee BOTH to eliminate the recent personal indebtedness of the housing/credit spree bubble in order to reset the economy, AND also in the form of a dividend to create and maintain monetary and economic equilibrium because velocity is continually inadequate due to the deeper and more costly accounting cycle that money, being virtually exclusively debt has with the Banking system.

    Hence Banks and their product of Debt lack a symmetrically powerful and equillibrating monetary paradigm, namely monetary Grace, the free gift.

    As above, so below. Symmetry, reflection, balance and so equilibrium in BOTH the economic and monetary system.

    Monetary, Economic and Spiritual Synthesis Theory (MESST)

  4. I’m firmly based in the micro economy, struggling like millions of others to earn their daily bread. It fascinates me that many correspondents on your threads Aziz, and to some extent yourself, all seem to firmly believe that the micro economy and the macro economy are different entities which require to be treated differently. I do understand that the macro-economy is very different to the micro economy, but the former wouldn’t exist without the millions of micro economic units to support it. Growth cannot continue for ever. I was lambasted previously for using the biological analogy of exponential growth of algae in a pond coming to a screeching halt and then starting all over again later after the ecosystem has stabilised. The financial macro economic ecosytem that the micro economic units exist in, namely your personal finances and mine, are all governed by emotional and other biological perogatives. Central planners like the Fed and academic armchair economists can measure reams of figures and apply their mathematical algorithms as much as they like, but if millions of micro economic units are being over -taxed, over -regulated and emotionally disincentivised by their policies, the macro economy will eventually go to hell whatever the Fed does. Increasing public spending was intended by Keynes as a tool to be applied strategically in hard times against the backdrop of a sound currency. America and the rest of the West tied to the dollar’s umbilical have instigated QE infinity against the backdrop of dubious currencies, an explosion of credit such as the world has never seen. America has gone from being the world’s greatest creditor to it’s greatest debtor in one generation. this has been accomplished by supposedly clever economists at the Fed ‘managing’ the macroeconomy. I don’t think the world can take much more public spending before something cracks. The financial ecosystem is going exponential at the moment. If governments don’t get a grip on their out of control spending, Mr Market will teach us all a lesson we’ll talk about for generatiions.

    • It fascinates me that many correspondents on your threads Aziz, and to some extent yourself, all seem to firmly believe that the micro economy and the macro economy are different entities which require to be treated differently.

      I certainly don’t forget that the macroeconomy is made up of individuals. That’s why I’m so worried about unemployment. Every unemployed person who can’t get a job due to a weak economy is an individual whose hopes and dreams is being crushed by a broken system and bad policy. It’s a person still living with their parents who can’t afford to move out. It’s a person who is renting and living from hand to mouth when they would much prefer to be able to get a job to buy a house.

      Growth cannot continue for ever. I was lambasted previously for using the biological analogy of exponential growth of algae in a pond coming to a screeching halt and then starting all over again later after the ecosystem has stabilised.

      Growth cannot continue for ever, but there’s an exponentially greater amount of energy in the solar system, the galaxy and the universe than we are currently using. It will take a long time before we hit a real barrier to growth, though there may be some bumps in the road.

      Central planners like the Fed and academic armchair economists can measure reams of figures and apply their mathematical algorithms as much as they like, but if millions of micro economic units are being over -taxed, over -regulated and emotionally disincentivised by their policies, the macro economy will eventually go to hell whatever the Fed does.

      Here’s the thing: we had full-employment before the crash. And the regulatory environment was just as severe. That’s not to say that I don’t think a less severe regulatory environment for entrepreneurs wouldn’t help. It would. But the issue in the depression can’t be the over-regulation, because the regulatory regimes haven’t hugely changed between before and after. The issue appears to be mass deleveraging by the small economic units you’re talking about, individuals and small businesses.

      America has gone from being the world’s greatest creditor to it’s greatest debtor in one generation. this has been accomplished by supposedly clever economists at the Fed ‘managing’ the macroeconomy.

      This has a lot to do with globalisation, the rise of Asia, the demand for the dollar as a global reserve currency, American foreign policy, and very little to do with the Fed.

  5. The rate of flow of prices at the moment of a product or service’s initial creation, that is on the lower end or at the beginning of the pricing system, will, by cost accounting rules, always exceed the rate of flow of individual incomes simultaneously created. Now even if money re-circulates, 98% of it is created as a debt by Banks and so the more underlying cost accounting cycle between businesses and Banks extracts sufficient amounts of money before it is actually re-circulated back through a business whereupon it is then also once again subject to the rules and effects of cost accounting (rate of prices exceeds rate of individual incomes to liquidate). Toss in nasty little factors like re-distributive taxation which also subtracts from individual purchasing power, and velocity is never able to be sufficient to equillibrate individual incomes and prices and hence the economy. Then, because adventure inevitably occurs in the temporal universe and because (let’s admit it) in a profit making economic system the tendency/temptation will always be to add to price, and finally because of the generally missed aforementioned disequilibrium on the lower end of the pricing system the necessity to inject money/debt into the economy just to keep it “in the air”makes the will also make for both monetary inflation AND the continual build up of debt. Of course we can also throw in things like outsourcing,/wage arbitrage and undoubtedly more significantly the rapidly accelerating effects on individual purchasing power of technological innovation….and can there be any doubt that the real problem of economics is the scarcity of individual income? Oh, and I forgot to mention that a private Banking license insures not only a monopoly on credit creation (somewhat of an anomaly in a supposed free market system) and even more importantly a self interested and utterly restrictive paradigm on the form of credit issued, namely loan ONLY. These obviously asymmetrical, unbalanced and dominating realities can only be redressed by the addition of a transformational paradigm of individual monetary Grace, the free gift….in the interests of equilibrium….and individual freedom.

  6. Austrian economists, in their scientistically unwhole atheism, mistakenly lost sight/threw the baby (the necessary and psychologically balancing effects of confidence, hope, love and grace) out with the bathwater (religion). This is no drum beating for religion of course, but for symmetry (reflection) balance (equilibrium) wholeness (inclusiveness) and integration (wisdom) in all things….most particularly in the currently religiously fraught areas of human endeavor of economics and money systems.

  7. China real estate bubble will burst, the shock generated will send US into deflation even without taper, the fed will then respond by double, triple, quadruple, quintuple the current rate of QE.

  8. Hi John,

    I have some sympathy for the Misesian position, but not for their reasons. As you say, John, base money creation would have to be a) far more extensive and b) have a far more direct effect on broad money to result in the hyperinflation that they fear. The real risks come from the market effects of persistent QE.

    Central banks have become the largest players in global markets. It is somewhat unclear as to whether markets respond to central banks or vice versa – it’s probably a bit of both – but we really can’t ignore the effect of central bank actions on global markets. The one thing we KNOW QE does is support asset prices – all classes of asset, not just government bonds and MBS. Global markets have become used to that support: investment decisions are governed to a large extent by the desire either to avoid capital erosion on safe assets (hence moves into assets that give zero yield, such as cash – zero yield is better than negative yield) or find some positive yield somewhere. Tapering is removing central bank support of asset prices. Unless not just the US economy but the GLOBAL economy is “on the up” at the time that tapering commences, the result of tapering will be a global fall in asset prices. That isn’t going to cause hyperinflation, but it would cause a global recession.

    I’m afraid it is not US fundamentals, but global fundamentals that will determine the Fed’s ability to taper. If the Fed tapers when the global economy is already in the doldrums, as it is at the moment, the recessionary rebound to the US economy would be considerable.

    I also think it would be highly irresponsible of the Fed to cause a global recession by ill-judged tapering. Because of the US dollar’s pre-eminence (and the pre-eminence of USTs, too – we don’t talk about that enough), the Fed is effectively the world’s central bank. It is high time that the US accepted that its monetary (and fiscal) policies must be driven by the needs of the global economy, not just the US. The “exorbitant privilege” is an exorbitant responsibility, too.

    I suppose I should write about this, shouldn’t I?

  9. I agree that the Fed is supporting asset prices. But not yields. I don’t know the extent to which the bond-buying is suppressing yields — I think that due to the depressed economy they’d be pretty low anyway — but the Fed is certainly pushing. While it may not make that much difference in the current depressionary economy, ending that push ceteris paribus might just counterbalance the effect on asset prices.

    Global GDP growth is actually looking relatively okayish. Not great, but we’re not in a global recession:

    A key question, I think is just how addicted to stimulus the market has gotten. If the Fed pulls out the monetary punchbowl and the market reacts badly, the resultant recession could be driven almost entirely by expectations. If so the Fed’s actions are running mostly on the placebo effect. Perhaps there is an element of truth to this, and perhaps withdrawing the monetary punchbowl right now would entail a nasty pullback. The idea is to get to an environment where that isn’t the case and to taper from there.

    In my view, the asset purchases are a kind of psychological placebo. Yes there is an element of liquidity provision, but the lack of liquidity was itself the outcome of a market freak out. The monetary placebo pills were not necessary before the depression. I think eventually, the economy will get a lucky positive shock and recover on its own. The idea is that the stimulus just keeps the economy on its feet until it finds its mojo again. In my former incarnation as an Austrian I was concerned that keeping the economy on life support without liquidating was just encouraging the misallocation of capital. Maybe there is an element of truth to that, especially when it comes to bailing out the worst and most rapacious of the bankers. Yet maybe the placebo effect is stronger than I and other monetary sceptics think that it is. And maybe by increasing the rate of purchases and inflating the economy the Fed can trigger much stronger real (i.e. as a percentage of GDP) deleveraging, leading to stronger growth (due to businesses once again being able to expand) and lower unemployment. And of course, eventually the fiscal side may realise that it needs to real get its act together to engender a recovery, and start looking after unemployment, resulting in a similar effect. At that point — whether we get there by a stroke of good luck like a technology shock, or by monetary or fiscal policy — the Fed can and will taper.

    Obviously, that is not the case now. And maybe the market would have never gotten hooked on monetary placebo pills if the Fed had just let the market liquidate. That’s the Austrian in me speaking. But maybe the liquidation we would have seen without the placebo pills would have been so horrendous that we’d have had a -35% contraction or something, 30% unemployment. So it’s really quite hard to say whether it was worth it or not. Yet I am confident that at some point the Fed will get a chance to taper. Economies like to grow. People like prosperity. And the fact that we can have prosperity simply by getting into the right mood and starting to allocate resources in a manner consistent with prosperity (i.e. high growth, low unemployment) suggests to me that sooner or later the mood will change. Obviously, there is tonnes of empirical evidence that depressions happen. They can last. They can become ingrained as a kind of bad equilibrium. But Yellen of all people understands this, and if anyone in monetary policy can navigate an exit — by getting unemployment low, growth higher, and the real debt load down — I think it is her.

    In conclusion, yes tapering now would be a poor idea that could easily put the world back into recession, and it would be irresponsible of the Fed to do so now. Whatever the efficacy of monetary policy, it is silly to be having a discussion about whether to taper in 2013, 2014 — the kind of silliness symptomatic of VSP types. We should be annoyed at Bernanke for having played into that. 2015 seems the very earliest we can expect to see sufficient macroeconomic evidence that tapering may be justified. But there is no guarantee that this situation will continue. Most likely an exit opportunity will come long before the USA or UK has had a full-on 20 years in the trap like Japan (mostly because Japan’s problems are increasingly demographic).

    • Crikey, it certainly is an essay – and a chart, too!

      I like your placebo analogy, though personally I see QE as more like tranquillizer or antidepressant pills. Point is the markets have become hooked on central bank intervention: someone described it to me as “like a drug”. So the Fed is right to talk about “tapering off” rather than sudden withdrawal of support – the last thing we need is global markets going cold turkey. The problem is the timing and pace of tapering. My general point is that has to be driven by market needs, not US economic fundamentals.

      If QE is supporting asset prices it is also, by definition, suppressing yields. The implication is that without QE, global asset prices would be lower and global yields higher. I am not primarily concerned about developed country bond yields: I think a much bigger risk is in emerging markets. Sudden yield spikes due to capital outflows on cessation of QE could be catastrophic for them. Even the prospect of QE tapering was enough to cause destabilising capital runs on emerging markets, remember.

      I didn’t say the global economy was in recession. I said it was in the doldrums, which actually is becalmed (i.e. stagnating). That’s consistent with your chart and with the IMF’s global outlook.

    • “In my former incarnation as an Austrian”

      What made you change into whatever it is that you are now (Keynesian?)?

      Most austrians you encounter online seem to believe that ‘austrian economics’ is absolute truth, and they just flat out refuse to acknowledge that any other school might have some validity. They will go to any length to make up arguments to defend their cherished ideology.

    • If the economy improve, the fed will taper, and the market will crash, there’s no such thing as “escape velocity” because the economy is not a rocket that given enough push will fly off on its own.

      • Correct….unless we provide and equitably distribute a source of individual income (dividend) which enables the equillibration of total individual incomes and total prices and so resolves the most fundamental problem causing the continuing economic disequilibrium historically attending “free” market theory.

  10. imagine try to help a crippled person regain his ability to walk. You don’t hold his hands for a long long time, then one day suddenly remove his support. The correct way is to support him for a short period, remove support, if he falls down, support him again, repeat many many times. If you support him for long long time, he will become completely psychologically and physically dependent on your support.

    • If that were the case the wealthy would have crashed and burned long ago. And even 90% of the non-wealthy generally find some kind of positive purpose. Abundance and the problems of abundance are much preferable to scarcity and the constant application of scarcity.

  11. Monetary scarcity in a modern technologically advanced highly productive economy…..is stupid. And economics and economic theory will remain stupid until it cognites on that fact.

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