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Wealth is not determined by money

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It is a journey,
not a destination

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Putting it all together

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Blog Posts
 

Tightrope To Tighten Through Taper

It is simply a balancing act. Not the vicarious performer in the picture, but the monetary policy of The Fed.

The Fed made a decision, during the Financial Crisis to have a loose monetary policy. Once the interest rates were lowered to essentially zero, they continued to increase the money supply by buying back Government Bonds. In 2007 the Fed's balance sheet showed excess reserves (basically the bonds they have purchased) of about $13 billion. Earlier this year, the Fed's excess reserves had grown to $1.7 Trillion. In a bit over 5 years the Fed's excess reserves have grown over 1300%! And the excess reserves are continuing to grow because the Fed is buying $85 billion in bonds every month.

Monetary policy cannot er, should not stay this easy forever. But extreme care must be taken to make certain the economy does not slip in the process.

This summer the Fed revised their guidance to let us know that before it starts to raise interest rates, it would first slow down the bond buying program. Since the interest rates will be kept low, the Fed said there were not 'tightening' monetary policy, they would simply be 'tapering' bond purchases. Wall Street responded with the financial equivalent of a temper tantrum; bond prices dropped and yields suddenly increased signifying the end of a 30 year bull market for bonds.

Economically, the response can be explained with simple supply and demand concepts. If the largest buyer of bonds stops buying, demand for bonds drops. If you assume a constant supply of bonds and lower demand, the price will naturally fall. And if the largest buyer of bonds were to suddenly become the largest seller, now you have decreased demand with increased supply and prices would rapidly decrease.

Keep in mind that the Fed didn't actually do anything… all they did was announce future intentions… and it rocked the market until the situation in Syria overshadowed the news.

If tapering was the only issue eventually supply would adapt and prices would stabilize, but after the taper will come the tightening. Tightening of monetary policy would be decreasing the money supply by the Fed increasing interest rates. Always remember the basic bond pricing relationship. When interest rates rise, bond prices fall.

Traditionally bonds have been a haven for safety and income. Investors who plan to hold their bonds long term to maturity really shouldn't care about market value. But investors in bond funds, or who need to sell their bonds prior to maturity, should be wary. We may be heading into a secular bear market for bonds.

So why doesn't the Fed just keep an easy position and avoid a bond market heartache? Because even though there may be some short term pain, capitalism needs a free and open market; not one constrained through government influence. I have never seen a better explanation of the long term benefits by removing government influence than Brian Westbury's two part video series "Keynesian Fallacy". The two videos are well worth the 15 minutes.

Westbury 101: Keynesian Fallacy Part 1

Westbury 101: Keynesian Fallacy Part 2

 

Photo Tightrope by Englishpointers (Hate Sleep Apneoa)