Should the Federal Reserve taper its bond buying program?

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DociReport

Since Quantitative Easing 3(QE3) started in September2012 the Federal Reserve  began purchasing 40 billion dollars worth of mortgage-backed securities a month. Four short  months later they started buying an additional $45 billion dollars worth of treasury bonds each month for a grand total of $85 billion a month.  The theory behind this plan is: the program should drive mortgage and treasury rates down while at the same time driving up demand for homes and make the cost to borrow money cheaper. In short, the Fed hoped this would help drive the economy and bring down the unemployment rate.

Now in December 2013 a little over a year later the Federal reserve has been torn on whether or not it should begin tapering its 85 billion dollar a month bond buying program. The initial plan was to curb the program when the unemployment rate dropped to around 7%. The unemployment rate hit this mark in the past month. However, using the unemployment number alone is a poor measure. It only takes into account those who  have looked for work in the past month. It does not consider other important factors. For example, if someone was working 40 hours a week and due to the struggling economy their hours are cut back to 20 hours a week they are still considered employed even though they are now only a part time employee. Another unconsidered factor is, those who have stopped looking for work for over a month are not counted and it makes the unemployment number drop considerably.

Back to QE3: One thing QE3 has certainly done is boost the stock market.  The Dow Jones recently closed over $16,000 for the first time in history which is unusual because it means that there is a disconnect between the stock market and the true economy. A lot of money has found its way into the stock market because there is no other place where investors can make money.  Normally, investors like the security and decent return of the 10-year treasury bond but with interest rates so low it does not make sense to buy them.  Since April, there has been more of a demand for these bonds so the interest rate has been steadily climbing.  This is the same interest rate the Fed has been trying to suppress for the past 16 months and creates the question ‘Is the Fed ready to taper?’

This week the Federal Reserve will have a meeting to decide if they will taper QE3. What will happen depending on what they decide to do?

Option 1. Nothing Changes: The Fed will continue to “print money” to buy these bonds in order to “boost the economy.” Eventually, if enough time goes on while the Fed continues to buy assets the dollar will be devalued so much that no one will want it and will result in a huge economic collapse. The real question here is when will people think the US dollar is at that point? Some like Ben Bernake, Fed chairman, believe that point is very far into the future and is not an issue that we will have to deal with. Others believe that point is fairly near and could be disastrous for the US.

Option 2. A small taper: Instead of buying 85 billion a month it will be some arbitrary number like 75 billion a month. This will allow interest rates to slowly rise and investors will in theory slowly gravitate towards bonds. This will result in interest rates rising further prompting more investors to get into bonds creating a cycle that will continue until an equilibrium is reached. While this is happening the stock market will be steadily decreasing because the money is flowing out and into the bond market.  The next likely step in this scenario is that when the market starts to drop the Fed will ramp the bond buying program back up to its highest levels if not higher because a major weakness has been shown in the economy.  Since this is such a strong possibility scenario 1 becomes more likely to play out.

Option 3. The Fed cuts QE3 all together.  This is extremely unlikely because it would cause an instant stock market crash. Interest rates would sky rocket, a lot of money would flow very quickly from the stock market to the bond market just like in scenario 2 but at a much faster pace. It would bring the US into another recession, but would likely result in a stronger US economy after the recession, if the bond buying program isn’t reinstated.

What do you think the Fed should do this week?

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