Tapering vs. tightening issue continued

Last week all (investors’) eyes were on the Fed, and the Fed delivered. A small (if you can call $10 billion “small,” but it is on a relative basis) form of tapering of the quantitative easing program was announced and markets reacted to it. It turned out that our assumptions about investors’ expectations were correct – they were expecting to see no tapering and they were surprised by it.

As mentioned previously, even though tapering and tightening are often viewed as synonyms, they are not exactly the same thing. Let’s discuss this more thoroughly.

Tapering and tightening are rightly interpreted as backing out from two distinct expansionary tools. Even though those two tools have similar effects on the market interest rates, they are not viewed as equivalent. Moreover, as Bernanke willingly admitted, the Federal Open Market Committee does not know the exact consequences of long term asset purchases (therefore contrary to Dennis Lockhart’s – Federal Reserve Bank of Atlanta – claim it is not easy to understand when the economy is “ready” for backing out). As he softly stated apparently they are “somewhat less certain about the magnitudes of the effects on financial conditions and the economy of changes in the pace of purchases or in the accumulated stock of assets on the Fed's balance sheet.”

Let us look closer than on those two different tools that Fed used to bring down longer term interest rates. First the conventional tool, short-term interest rates, which started being reduced after the first symptoms of the coming recession:

As fast as Bernanke took office and started rising the interest rates he had to start lowering them after the holiday season in 2007.  The hit in 2008 and the Lehman fall only perpetuated the trend. In 2009 the Fed gladly and proudly started to walk in the world of near zero interest rates (negative real interest rates, the same diseases as the one that initially caused 2007-8 trouble). As you easily see, this “temporary” tool has become almost permanent as in the case of Japan. Interest rates are not moving anywhere soon. No “tightening” should be expected, since all the inflation hawks emigrated to parts unknown.

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