How Markets Misunderstand the Fed's 'Taper' Economy

September 25, 2013

NEW YORK (Sept 25)  How long will the Federal Reserve's helping hand keep guiding the U.S. economy?

The answer still seems to be "as long as it takes." In the meantime, fears about "tapering," the gradual wind-down of billions in monthly Fed bond purchases that's keeping interest rates low now, have caused widespread confusion and market volatility. For people buying homes, refinancing debt or investing for retirement, it's an important question. The Fed itself has said repeatedly that it will stay the course until the recovery is assured.


The real debate centers on the actual strength of the economy and what it says about Fed policy. Mixed signals on that score have caused markets to churn in recent weeks, marked by waves of record short-term fund flows in and out of equities, gold and bond funds.

Experts warn that people are reading too much into day-to-day events such as the timing of the taper. "Investors need to be careful. They can get really whipsawed," says Jerry Webman, chief economist for OppenheimerFunds. "You really need to not get caught up in these short-term market fluctuations and announcements."

What is the source of the confusion?

There is no timetable for Fed policy on rates. Back in June, Federal Reserve Chairman Ben Bernanke said the Fed might taper as early as September, but only if conditions were right. By holding off on that action this month, the central bank clearly showed it will wait to do so until the economy can manage higher rates. It will not be bound to any timetable. Its focus is entirely on the economy.

Tapering itself has been too big a focus. The unusual bond-buying program was a response to a unique situation. Long-term rates were stubbornly high despite years of Fed easing. The 30-year Treasury yield plummeted to an all-time low below 2.5 percent, and 30-year fixed mortgage rates followed to their lowest level ever at below 3.5 percent.

Those rates have since popped higher but still remain "well below the level of mortgage rates even at the peak of the housing boom," Webman says. The 30-year average has risen above 4 percent and could edge higher, Webman says. Still, mortgage rates are well below where they were even at the peak of the last housing boom, and they're affordable enough to allow a healthy level of home purchases to continue (however, higher rates have slowed refinancings, which are based entirely on relative interest-rate levels and not on affordability measures. People get refis only when rates are dropping.)

Meanwhile, the Fed will do what it has been doing for years, providing enough credit for the economy to grow. In a note to clients after last week's Fed meeting, Fran Rodilosso, fixed-income portfolio manager at Market Vectors ETFs, said he believes "easy money is a given into 2015."

The Fed does not need to continue its long-term bond buying to keep rates low, Rodilosso says. It can influence a broad range of consumer and professional lending by using short-term rates, something it has done effectively for years.

"The Fed has been managing the economy to various degrees since the mid-1950s," says Fred Dickson, chief investment strategist at D.A. Davidson. "I don't see that changing in the next decade."

The decision not to taper does not mean the economy is sliding, as some suggest. Despite big market swings, there has been little change in the economy this year. It has continued to expand at a modest rate of just over 2 percent, and it is expected to keep doing so.

The Fed's disclosure that it might pull back from its unusual bond-buying plan was not based on any dramatic change in the economy, but on the view that things have not improved enough for a policy change. "The economy will keep growing gradually if nothing drastic comes out of the current budget deliberations," Webman says.

The budget uncertainty was one of the reasons the Fed held off on taking action at its September meeting, economists agree. That political showdown could lead to cutbacks in federal spending that could put a new drag on the economy. September also began with a relatively weak employment report that played a role in the Fed's decision.

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