Why no one is afraid of tapering any more

 yellen_janet_040512_8x10Vivek Kaul  
The only economic theory that works all the time is that no economic theory works all the time.
Since May 2013, analysts, economists and journalists have fettered over what will happen once the Federal Reserve of the United States, the American central bank, starts to taper.
The Federal Reserve had been printing $85 billion every month to buy bonds. By buying bonds, the Federal Reserve pumped money into the financial system. This was done so as to ensure that there was enough money going around in the financial system leading to low long term interest rates.
Since December 2013, the Federal Reserve has been cutting down on the amount of money that it has been printing to buy bonds. This cut down in the total amount of bonds being bought by the Federal Reserve by printing money, is referred to as tapering.
In a statement released yesterday (i.e. March 19, 2014) the Federal Open Market Committee (FOMC) said that henceforth it would buy bonds worth only $55 billion, every month. At the current pace it is expected that the Federal Reserve will stop printing money to buy bonds by October 2014.
When Ben Bernanke, who was the Chairman of the Federal Reserve till February 3, 2014, had first suggested tapering in May 2013, it spooked financial markets all over the world very badly. Institutional investors had borrowed money at low interest rates prevailing in the United States and invested that money in financial markets all over the world.
This trade referred to as the dollar carry trade wouldn’t be viable any more, if the Federal Reserve started to taper. Tapering would ensure that the amount of money floating around in the financial system would come down and hence, interest rates would start to go up.
And once interest rates started to go up, the dollar carry trade wouldn’t work, that was the fear among institutional investors. This would lead to them selling out of financial markets all over the world and taking their money back to the United States.
In the Indian context it would have meant the foreign institutional investors exiting both the Indian stock and bond market. As they would have converted their rupees into dollars, there would have been pressure on the rupee, and the currency would have depreciated against the dollar.
In fact, between the end of May 2013, when Bernanke suggested tapering for the first time, and August 2013, the rupee fell from 55.5 to a dollar to close to 69 to a dollar. A lot of money was withdrawn from the Indian bond market by foreign institutional investors. Also, between June and August September 2013, the foreign institutional investors sold out stocks worth Rs 19,310.36 crore from the Indian stock market.
But after yesterday’s decision by the FOMC to cut down on bond purchases by $10 billion to $55 billion, the financial markets around the world have barely reacted.
The S&P 500, one of the premier stock market indices in the United States, fell by around 0.61% yesterday. Closer to home, the BSE Sensex, has barely reacted. As I write this it has fallen by around 28 points from yesterday’s closing level and is currently quoting at 21,804.8 points.
So, what has changed between May 2013 and March 2014? Since December 2012, the Federal Reserve had been following the Evans rule (named after Charles Evans, who is the president of the Federal Reserve Bank of Chicago). As per this rule, the Federal Reserve will keep interest rates low till the rate of unemployment fell below 6.5% or the rate of inflation went above 2.5%.
The rate of unemployment in the United States has been falling for a while and currently stands at 6.7%, very close to the 6.5% mandated by the Evans rule. The trouble here is that the unemployment number has not been falling because more people are finding jobs. It has simply been falling because more people have been dropping out of the workforce. The unemployment rate does not take into account people who have dropped out of the workforce. It only takes into account people who are still in the workforce and are not able to find jobs.
In December 2013, nearly 3,47,000 workers left the labour force because they could not find jobs, and hence, were no longer counted as unemployed. This took the number of Americans not working to a record 102 million. As Peter Ferrara puts it on Forbes.com“In fact, 
all of the decline in the U3 headline unemployment rate since President Obama entered office has been due to workers leaving the work force, and therefore no longer counted as unemployed, rather than to new jobs created…Those 102 million Americans are the human face of an employment-population ratio stuck at a pitiful 58.6%. In fact, more than 100 million Americans were not working in Obama’s workers’ paradise for all of 2013 and 2012.” Interestingly, the labour force participation rate, which is a measure of the proportion of working age population in the labour force, has slipped to 62.8%. This is the lowest since February 1978.
In it’s latest policy statement issued yesterday, the Federal Reserve seems to have junked the Evans rule. As the statement said “In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.” Federal funds rate is the interest rate that banks charge each other to borrow funds overnight, in order to maintain their reserve requirement at the Federal Reserve. This interest rate acts as a benchmark for business and consumer loans.
What this means is that instead of just looking at the rate of unemployment and the rate of inflation, the Federal Reserve will take a look at other factors as well, before deciding to raise the Federal funds rate. What this tells the financial markets all over the world is that the Federal Reserve will continue to ensure low interest rates in the United States, in the time to come, even though it will most likely stop printing money to buy bonds by October 2014.
In fact, in the press conference that followed the FOMC meeting, Janet Yellen, the Chairperson of the Federal Reserve was asked how long did she think would be the gap between the end of bond buying and the Federal Reserve starting to raise interest rates. “It’s hard to define but, you know, probably means something on the order of around six months,” replied Yellen.
This spooked the financial markets briefly because it meant that the Federal Reserve would start raising interest rates by around April next year. But Yellen quickly clarified that any decision to raise interest rates would depend “on what conditions are like”.
So what this means is that the Federal Reserve will ensure that interest rates in the United States continue to stay low. Hence, the dollar carry trade will continue, much to the relief of global institutional investors.
Peter Schiff the Chief Executive of Euro Pacific Capital explained the situation best when he said “The Fed will keep manufacturing excuses as to why rates can’t be raised. Whether it’s a cold winter or a hot summer, a geopolitical crisis, or an unexpected sell-off in stocks or real estate, the Fed will always find a convenient excuse to postpone tightening. That’s because it has built an economy completely dependent on zero percent interest rates. Even the smallest rate shock could be enough to push us into recession. The Fed knows that, and it is hoping to keep the ugly truth hidden.”
To cut a long story short, the easy money party will continue.
The article originally appeared on www.FirstBiz.com on March 20, 2014, with a different headline
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Why the markets are reading too much into Larry Summers' withdrawal from Fed race

larry summers Vivek Kaul 
Larry Summers withdrew from the race to become the next Chairman of the Federal Reserve of United States on September 15, 2013. He was believed to be American President Barack Obama’s favourite candidate. (To read why he withdrew from the race click here)
The markets around the world immediately cheered his withdrawal. This happened primarily because Summers was widely seen to be what in central bank speak is termed as a ‘hawk’. A hawk is someone who is likely to raise interest rates and cut down on money supply.
Summers had said in April this year that “QE in my view is less efficacious for the real economy than most people suppose.” QE stands for quantitative easing and refers to the money that the Federal Reserve of United States, the American central bank, has been printing and pumping into the financial system, in the hope of getting the American economy up and running again.
The idea here is that by flooding the financial system with money, the interest rates will continue to remain low, thus encouraging people to borrow and spend more. With people spending more money, businesses will perform better, and the economic growth would come back.
Summers, it is believed, thinks that the government directly spending money through 
stimulus programmes, would have a greater impact on the economic growth in comparison to the Federal Reserve maintaining low interest rates by printing money and hoping that people borrow and spend more money.
The markets believed that Summers would stop printing money faster than Janet Yellen, the current Vice-Chairwoman of the Federal Reserve, who is now the front runner for the top job at the Federal Reserve.
Currently, the Federal Reserve prints $85 billion every month, which it pumps into the financial system by buying bonds. Ben Bernanke, the current Chairman of the Federal Reserve of United States, has indicated over the last few months that the Federal Reserve will go slow on money printing in the days to come.
This is a big worry for the markets. The idea behind all the money that is being printed has been that at low interest rates people will borrow and spend more money, and thus economic growth will return. But more than that what has happened is that investors have borrowed money available at very low interest rates and invested it in financial and other markets around the world.
This has led to big bubbles in these markets. 
As economist Bill Bonner writes “Works of art are selling for astronomical prices. High-end palaces and antique cars are setting new records. Is this reckless money hitting the stock market too?” Easy money is showing up in all kinds of places.
If the Federal Reserve goes slow on money printing, interest rates are likely to spike, making it difficult for investors who have enjoyed the benefits of the ‘dollar carry trade’ to continue enjoying it. Summers, the markets had come to believe, was more likely to stop money printing faster than any other candidate. And now that he is out of the race, the era of ‘easy money’ policies is likely to continue for a slightly longer period.
The situation needs a slightly more nuanced reading than this. 
As Martin Fridson writes on Forbes.com “The main, rather thin basis for portraying Summers as a hawk was a single remark he made in April about the Fed’s quantitative easing (QE) program: “QE in my view is less efficacious for the real economy than most people suppose.” This was not a major, formal policy statement, but a comment within an official summary of Summers’ remarks at a conference.”
the Federal Reserve’s own research has showed as much. More than that even if a economist believes that quantitative easing hasn’t been effective, that doesn’t mean that he also believes that the Federal Reserve should go slow on it.
As Nobel Prize winning economist Paul Krugman 
writes in a recent column in the New York Times “One answer is the belief that these purchases…are, in the end, not very effective. There’s a fair bit of evidence in support of that belief.” The Federal Reserve puts the money that it prints into the financial system by buying bonds.
Even though, Krugman believes that quantitative easing hasn’t been very effective, he still recommends that it is important to continue with it. “Time for the Fed to take its foot off the gas pedal?” asks Krugman and then goes onto explain why that would not be the right thing to do.
He feels that any suggestion of the Federal Reserve going slow on money printing is going to lead to the long term interest rates in the United States going up. And this can’t be good for the overall American economy, which has just started to show some signs of revival.
Hence, the point here is that even though economists may understand that money printing has not been very effective, at the same time they may not want to go slow on it.
Summers also thinks that government stimulus programmes are likely to be more effective, there was not much that he could do about it. Any extra spending by the American government would mean it would have to borrow more money. This would be a problem given that the government has almost touched its debt limit of $16.7 trillion. 
As the Reuters reports “The government has been scraping up against its $16.7 trillion debt limit since May but has avoided defaulting on any bills by employing emergency measures to manage its cash, such as suspending investments in pension funds for federal workers.”
And more than that the Republicans don’t seem to be in any mood to let the government increase its spending. As an Associated Press news report points out “What’s more, massive fiscal stimulus is highly unlikely given opposition from congressional Republicans to increased spending.”
Given these reasons it is highly unlikely that Larry Summers would have been able to do anything dramatically different from what the Bernanke led Federal Reserve is currently doing or from what the Yellen led Federal Reserve(which is how it seems like right now) might do in the days to come. As Fridson writes on Forbes.com “My point is rather that the range of policy options will be limited for whoever steps into Ben Bernanke’s shoes. 
Barack Obama was never going to nominate a Fed chairman who would diverge from the narrow list of realistic choices regarding interest rates.”
(Vivek Kaul is a writer. He tweets @kaul_vivek)