What happens if the economy hits some rocks? Will the Fed stop the taper?

Summary: The first phase of the great monetary experiment was guaranteed pleasure. Whatever the results, monetary stimulus feels great. Then comes the difficult process of withdrawing the stimulus. “Tapering”, as its called by economists (and, coincidentally, by heroin addicts). How much damage will be cause? How much pain? Today we have advice about what to expect from someone with more experience at this game than most economists.

One fascinating about political economy (the intersection of politics and economics) is the how frequently people believe with total certainty things that are not so.

After Obama took office in 2009 many people “knew” that the Keynan socialist would inexorably expand the size of the government bureaucracy. In fact the Federal government’s workforce is up only 3.7% in the five years since then (less than the population increase of 4.3%), and down 4.4% since the May 2011 peak (vs population up 2.0%).

Many people “knew” that the has been no recovery from the great recession. Many people still believe this, despite the slow improvement in almost every economy measurement of the US economy (how that recovery has been shared is a different question).

The common element of such stories: they are both comforting and conform to their biases. What do people know now about the next phase of the US economy’s story? What comforting stories do they tell us?

Most economists believe that there will be only a small cost (or impact) from the taper, and probably even from the larger process of normalizing (i.e., tightening) monetary policy (including raising interest rates) of which the taper is just the first phase.
Many people, especially on Wall Street, believe that at the first signs of turmoil the Fed will stop the tightening cycle, or even reverse it.

We can only guess at the first of these, the results of the great monetary experiment. My guess is that the process will be difficult. See Government economic stimulus is powerful medicine. Just as heroin was once used as a powerful medicine.

For an answer to the second we turn to one of Japan’s top economists, who draws upon lessons learned not only from US history, but also from Japan’s quarter-century struggle with similar problems. He believes that for good or ill the Fed will stop the normalization process only after a “huge plunge” in markets or large bank failures.

“Fed tapering and emerging market turmoil”

By Richard Koo (Chief Economist), Nomura
4 February 2014

Minor shocks from emerging economies will not deter Fed

The recent market turbulence began with a steep fall in the Argentine peso, which quickly put pressure on other emerging market currencies. Nevertheless, the Fed’s Federal Open Market Committee (FOMC) not only decided to push ahead with tapering but also made no mention of the emerging market turmoil in its official statement. I suspect this is because — as argued in my last report — the Fed’s main scenario is likely to involve reducing asset purchases by an identical amount at each FOMC meeting, following the practice of former Fed Chairman Alan Greenspan, who successfully raised the federal funds rate by 425bp {basis point} this way in the 2000s.

Raising the policy rate by 25bp at each FOMC meeting was so automatic and predictable that once the market understood what the Fed was trying to do, long-term interest rates were largely unaffected by the tightening. The yield on the 10-year Treasury note rose just 60bp throughout the entire tightening cycle in spite of more than 400bp in rate hikes.

Today’s FOMC, which fears nothing more than an “unwarranted” rise in long-term rates, seeks a repeat of that experience. In that sense, I think it is extremely unlikely to abandon its current approach because of moderate turbulence in domestic or overseas markets.

Side effects of ending mechanical tapering would outweigh benefits

Dropping the Greenspan approach at this point and temporarily halting the tapering process would create more uncertainty for all future FOMC meetings, which in turn could lead to sharp advances in long-term rates, as we have seen since June of last year.

The FOMC most likely decided that a temporary halt to tapering and a resulting increase in the risk of rising long-term rates at future meetings would have heavy negative ramifications for both the US and emerging markets.

The FOMC would probably alter its policy if faced with the collapse of financial institutions or a huge plunge in share prices from current levels. Otherwise, I think the Fed sees the negative side effects of changing policy as outweighing the potential benefits.

Fed wants to taper while forward guidance is still in effect

Postponing tapering for one meeting would also create the expectation that the tapering process would be put on hold every time there was a hiccup in the markets. If that delayed the winding down of quantitative easing, monetary policy as a whole could fall behind the curve, sending long-term rates higher.

… there would be serious implications for the authorities and the markets alike if the FOMC began putting tapering on hold at each sign of market turbulence and inflationary pressures then emerged. In that scenario, the market would start to expect the Fed to raise short-term rates in addition to scaling back its asset purchases, rendering forward guidance — the pegging of the short end of the curve at zero — effectively useless.

The risk here is that long-term rates could surge to extreme levels if the Fed were forced to unwind quantitative easing without this anchoring of short-term rates.

I think the FOMC wants to proceed with tapering and, if all goes well, the unwinding of QE while the short end of the yield curve remains anchored at zero. Indeed that is the only reason that can justify the start of tapering at an inflation rate of only 1.2%. Given that the ongoing US recovery began in the highly interest rate sensitive sectors of housing and automobiles, the FOMC almost certainly wants to avoid an unreasonable rise in long-term rates, and if so it needs to keep moving ahead with tapering.

About the author

Richard C. Koo is the Chief Economist of Nomura Research Institute with responsibilities to provide independent economic and market analysis to Nomura Securities, the leading securities house in Japan, and its clients. Consistently voted as one of the most reliable economists by Japanese capital and financial market participants for nearly a decade, he has also advised successive prime ministers on how best to deal with Japan’s economic and banking problems. He is also the only non-Japanese member of the Defense Strategy Study Conference of the Japan Ministry of Defense.

Prior to joining Nomura, he was an economist with the Federal Reserve Bank of New York, and was a Doctoral Fellow of the Board of Governors of the Federal Reserve System.

Author of many books and a visiting professor of Waseda University, he was awarded the Abramson Award by the National Association of Business Economics for 2001. His latest book is The Holy Grail of Macroeconomics – Lessons from Japan’s Great Recession (2008).

For more about Koo’s view see:

“The world in balance sheet recession : causes, cure, and politics“, Real World Economics Review (journal of the World Economics Association), 1 December 2011

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