The U.S Fed Trades Short-Term Gain for Longer-Term Pain

Last Wednesday the U.S. Federal Reserve surprised global markets by deciding not to begin tapering its quantitative easing (QE) programs.

This was unexpected because the Fed had been warning about a QE taper for several months, by saying that the U.S. economy was now on a stronger footing and by repeating the phrase that “tapering is not tightening”, which emphasized the difference between reducing stimulus (tapering) and actually tightening monetary policy (raising interest rates).

When the Fed first warned markets that QE would not go on forever, it was the right thing to do. It had to counteract any belief that we had entered a period of “QE infinity” because that perception would fuel imbalances and distortions that would inevitably destabilize financial markets. Investors couldn’t be allowed to operate under the assumption that the Fed would print money forever.

The Fed now faces a difficult challenge as it tries to keep this warning credible while also balancing its many competing objectives. For example, after the Fed offered a more optimistic view of the recovery and warned that tapering could happen as early as the fall, U.S. bond yields surged higher and mortgage rates increased by more than 1% over a short period of time. Among other effects, this had a negative impact on housing market rebound, which the Fed believes is a critical element in the overall recovery.

So how exactly does the Fed keep people honest by warning them that QE won’t go on forever if this very warning undermines all of the hard-won momentum that made the Fed feel confident enough to issue this warning in the first place? I wrote about this enigma last month, calling it the Fed’s tapering conundrum.

On top of its many other challenges, after its failure to act last Wednesday, the Fed now has a credibility problem. The Bernanke Fed has tried to provide markets with an increased amount of forward guidance in an attempt to create more transparency around its decision making process. Markets don’t like central bank surprises. So, in theory, attempts to raise the Fed’s decision-making veil seemed like a sensible evolution in Fed policy. But in practice, at least so far, the Fed’s attempts at forward guidance have raised more questions than they have answered.

Here are some examples:

• The Fed’s growth forecasts throughout the Great Recession have proven wildly optimistic and anyone who made investment decisions using these forecasts might well be a lot poorer by now. If investors have learned anything from the Fed’s forecasts, it’s that the Fed’s crystal ball is just as murky as the ones everyone else is using.
• The Fed tied the tapering of its QE programs and the timing of its first policy rate increase to reductions in the U.S. unemployment rate, even though there was little evidence that Fed policy could directly impact employment. Furthermore, as I have pointed out many times before, the rise and fall of the raw unemployment rate does not give us a reliable gauge of the health of the employment market. For example, the U.S. unemployment rate has been falling recently, but that’s largely because a record number of discouraged workers have given up looking for work, thereby removing themselves from the official statistic. Because these people are no longer counted as technically unemployed, the U.S. unemployment rate falls, even though this can hardly be interpreted as an encouraging development. In theory, when the Fed designated the unemployment rate as its key gauge of the success of the recovery it was trying to give investors more predictability. In practice, however, the unemployment rate has proven an unreliable indicator because its ebb and flow leaves too much room for interpretation.
• There was a widespread perception that the Fed had been preparing the market for a taper announcement last week and investors responded by pricing in a small QE reduction of about $10 billion/month. While the Fed insisted at last week’s post-meeting press conference that it had promised no such thing, why did so many investors fall victim to the same misinterpretation?

Perhaps this was just the wrong time for the Fed to try to become more transparent. Maybe it would have been better off operating behind a curtain of mystery so that investors could continue to believe that the Fed knew more than the market. Instead of making its actions more predictable, the Fed’s efforts to become more transparent have backfired, fuelling uncertainty and heightening volatility.

So what does the Fed’s decision not to annouce the beginning of tapering mean for Canadian mortgage borrowers? Over the short term the Fed’s announcement should slow, or even somewhat reverse, the torrid run-up in Government of Canada (GoC) bond yields that we have seen lately. That’s good news for anyone in the market for a fixed-rate mortgage. Variable-rate borrowers who read this blog regularly already know that U.S. and Canadian monetary policies are tightly linked and since the Fed has said that it will not consider raising its short-term policy rate until it has completely unwound its QE programs, the Fed’s decision to keep its liquidity taps wide open should help push our next variable-rate increase farther into the future. Better still, at last week’s meeting the majority of the Fed’s voting members indicated that they now expect the Fed funds rate to remain at ultra-low levels through 2016, signalling a more cautious outlook on the economy and forecasting low rates for years to come.

So if the Fed’s announcement implies that both fixed and variable rates will stay lower for longer, why don’t I feel like celebrating?

I continue to believe that, in the fullness of time, the whole QE experiment would prove to be a Faustian bargain. For starters, while its negative effects are plain to see, the Fed’s third round of QE doesn’t appear to be producing much positive economic impact. We are left with massive expansion of the Fed’s balance sheet, world-wide asset bubbles, disruptive currency swings, inflated equity markets and on an overall basis, the rising fear that someday this will all end badly. Apart from that Mrs. Lincoln, how did you enjoy the play?

It seems that the Fed’s real goal with all of its market interventions has been to prevent any kind of short-term economic pain. Bluntly put, however, capitalism only works if creative destruction is allowed to cleanse the system. You can’t soar to the heights of economic growth without the momentum that is gained in the depths of economic failure and rebirth. Japan has suffered two decades of stagnation and deflation because it protected too many of its businesses from failure, allowing them to slowly rot from the inside out. If the U.S. follows the same general path, why should its fate be any different? The Fed is desperately trying to minimize the Great Recession’s economic pain, but doing so merely pushes costs into the future and compounds the price that must be paid by future U.S. taxpayers.

The Fed’s actions remind me of an analogy I once read about how sand piles work. As a sand pile grows, certain areas of weakness form and eventually a single grain of sand destabilizes the whole structure and causes a landslide (or in this example I suppose I should call it a “sandslide”). Each time the Fed adds another dollar of debt, it makes its massive and exponentially increasing balance sheet a little less stable while producing a rapidly diminishing return. As the Fed continues down its current path, I am becoming more and more concerned that at some point it will print one dollar too many. While that day stills appears to be a long way off, the ultimate results appears increasingly inevitable.

Five-year GoC bond yields fell by twelve basis points last week, closing at 2.00% on Friday. Most of that drop happened late in the week and therfore, only a few lenders have so far responded by lowering fixed rates. If the five-year GoC bond yield falls much below 2.00% early this week, I expect most lenders to follow.

Five-year variable rates are still being offered in the prime minus 0.50% range, which works out to 2.50% using today’s prime rate of 3.00%. The gap between fixed and variable rates is still above 1.00% and the case for variable rates grows even more compelling as key economic data continue to indicate that the Bank of Canada is unlikely to increase its overnight rate for some time yet. (A flat inflation reading of 1.1% from Statistics Canada last Friday provides the most recent reinforcement – if the Fed’s decision not to taper didn’t provide enough reassurance.)

The Bottom Line: The Fed’s decision not to taper was good short-term news for both fixed- and variable-rate borrowers because it should help rates stay at or near today’s ultra-low levels for the foreseeable future. That said, in the longer run, I think that this short-term gain increases the likelihood of much greater long-term pain.