Examining the Potential Unintended Consequences of the Fed's Tapering

Casey Research |

During World War II, the British Royal Air Force (RAF) undertook a plan of misdirection to allow a squadron of bombers to approach an exceptionally valuable target in Europe undetected. The target was so heavily guarded that destroying it would require more than the usual degree of surprise.

Although the RAF was equipped to jam the electronic detection of aircraft along the route to the target (a primitive forebear of radar was then in use), they feared that the jamming itself would alert the defending forces. Their solution was to “train” the defending German personnel to believe something that wasn't true. The RAF had a great advantage in undertaking the training: The intended trainees were operating equipment that was novel and far from reliable; and those operators were trying to interpret signals without the help of direct observation, such as actually seeing what they were charged with detecting.

At sunrise on the first day, the RAF broadcast a jamming signal for just a fraction of minute. On the second day, it broadcast a jamming signal for a bit longer than a minute, also around sunrise. On each successive day, it sent the signal for a somewhat longer and longer time, but always starting just before sunrise.

The training continued for nearly three months, and the German radar personnel interpreted the signals their equipment gave them in just the way the British intended. They concluded that their equipment operates poorly in the atmospheric conditions present at sunrise and that the problem grows as the season progresses. That mistaken inference allowed an RAF squadron to fly unnoticed far enough into Europe to destroy the target.

People will get used to almost anything if it goes on for long enough. And the getting-used-to-it process doesn't take long at all if it's something that people don't understand well and that they can't experience directly. They hear about Quantitative Easing and money printing and government deficits, but they never see those things happening in plain view, unlike a car wreck or burnt toast, and they never feel it happening to themselves.

QE has become just a story, and it's been going on for so long that it has no scare value left. That's why so few investors notice that the present situation of the US economy and world investment markets is beyond unusual. The situation is weird, and dangerously so. But we've all gotten used to it.

Here are the four main points of weirdness:

  1. The Federal Reserve is still fleeing the ghost of the dot-com bubble. It was so worried that the collapse of the dot-com bubble (beginning in March 2000) would damage the economy that it stepped hard on the monetary accelerator. The growth rate of the M1 money supply jumped from near 0% to near 10%. This had the hoped-for result of making the recession that began the following year brief and mild.
  1. A nice result, if that had been all. But there was more. Injecting a big dose of money to inoculate the economy against recession set off a bubble in the housing market. Starting in 2003, the Fed began gradually lowering the growth rate of the money supply to cool the rise in housing prices. That, too, produced the intended result; in 2006, housing prices began drifting lower.

    But again, there was a further consequence—the financial collapse that began in 2008. This time, the Federal Reserve stomped on the monetary accelerator with both feet, and the growth of the money supply hit a year-over-year rate of 21%. It's still growing rapidly, at an annual rate of 9%.

  1. The nonstop expansion of the money supply since 2008 has kept money market interest close to zero. Rates on longer-term debt aren't zero but are extraordinarily low. The ten-year Treasury bond currently yields just 2.7%; that's up from a low of 1.7%.

    The flow of new money has been irrigating all financial markets. In the US, stocks and bonds tremble at each hint the Fed is going to turn the faucet down just a little. And it's not just US markets that are affected. When credit in the US is ultra-cheap, billions are borrowed here and invested elsewhere, all around the world, which pushes up investment prices almost everywhere.
  1. US federal debt management is living on borrowed time. The deficit for 2013 was only $600 billion, down from trillion-dollar-plus levels of recent years. But this less-terrible-than-before figure was achieved only by the grace of extraordinarily low interest rates, which limit the cost of servicing existing government debt. Should interest rates rise, less-than-terrible will seem like happy times.

Almost no one imagines that the current situation can continue indefinitely. But is there a way for it to end nicely? For most investors, the expectation (or perhaps just the hope) that things can gracefully return to normal rests on confidence that the people in charge, especially the Federal Reserve governors, are really, really smart and know what they're doing. The best minds are on the job.

If the best minds were in charge of designing a bridge, I would expect the bridge to hold up well even in a storm. If the best minds were in charge of designing an airplane, I would expect it to fly reliably. But if the best minds were in charge of something no one really knows how to do, I would be ready for a failure, albeit a failure with superb academic credentials.

Despite all the mathematics that has been spray-painted on it, economics isn't a modern science. It's a primitive science still weighted with cherished beliefs and unproven dogma. It's in about the same stage of development today that medicine was in the 17th century, when the best minds of science were arguing whether the blood circulates through the body or just sits in the veins. Today economists argue whether newly created cash will circulate through the economy or just sit in the hands of the recipients.

Let's look at the puzzle the best minds now face.

If the Federal Reserve were simply to continue on with the money printing that began in 2008, the economy would continue its slow recovery, with unemployment drifting lower and lower. Then the accumulated increase in the money supply would start pushing up the rate of price inflation, and it would push hard. Only a sharp and prolonged slowdown in monetary growth would rein in price inflation. But that would be reflected in much higher interest rates, which would push the federal deficit back above the trillion-dollar mark and also push the economy back into recession.

So the Fed is trying something else. They’ve begun the so-called taper, which is a slowing of the growth of the money supply. Their hope is that if they go about it with sufficient precision and delicacy, they can head off catastrophic price inflation without undoing the recovery. What is their chance of success?

My unhappy answer is "very low." The reason is that they aren't dealing with a linear system. It's not like trying to squeeze just the right amount of lemon juice into your iced tea. With that task, even if you don't get a perfect result, being a drop or two off the ideal won't produce a bad result. Tinkering with the money supply, on the other hand, is more like disarming a bomb—and going about it according to the current theory as to whether it's the blue wire or the red wire that needs to be cut means a small failure isn’t possible.

Adjusting the growth of the money supply sets off multiple reactions, some of which can come back to bite. Suppose, for example, that the taper proceeds with such a light touch that the US economy doesn't tank. But that won't be the end of the story. Stock and bond markets in most countries have been living on the Fed's money printing. The touch that's light enough for the US markets might pull the props out from under foreign markets—which would have consequences for foreign economies that would feed back into the US through investment losses by US investors, loan defaults against US lenders, and damage to US export markets. With that feedback, even the light touch could turn out not to have been light enough.

To see what the consequences of economic mismanagement can be, and how stealthily disaster can creep up on you, watch the 30-minute documentary, Meltdown America. Witness the harrowing tales of three ordinary people who lived through a crisis, and how their experiences warn of the turmoil that could soon reach the US. Click here to watch it now. The article was originally published at caseyresearch.com.

By Terry Coxon, Senior Economist
Casey Research


DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer


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