Tapering vs. tightening nonsense

Can we please stop talking about whether tapering is tightening; pointing out that tapering is not tightening or coming to the conclusion that tapering is tightening after all.

Let’s make it clear. Tapering is tapering and tightening is tightening. The Federal Reserve tightens monetary policy when it believes the economy is getting a little too hot and risks creating inflation. It is the opposite of easing when the Federal Reserve cuts interest rates if the economy moves or threatens to move into recession. Tapering is the gradual reduction of the special monthly purchases of mortgage debt and long-term Treasuries the Fed has been buying since September 2012 (QE3).

The “Great Recession”, which began in 2007, hit hyper drive with the September 2008 failure of Lehman Brothers and technically ended in June 2009, was so severe that the Fed needed to keep interest rates —short-term and long-term—as low as possible for as  long as possible to support economic activity and keep lending activity going on.

In order to do that it cut short-term (Fed Funds) interest rates to near zero shortly after the apex of the credit crisis in 2008. This did not do the trick so it promised to keep rates near zero for a long time and then a very long time. That still did not do the trick so it embarked on quantitative easing. After two rounds of QE, the economy was still struggling so the Fed began to switch out the purchases of short-term instruments for longer-term instruments (operation twist) and that was still not enough so it embarked on open ended Treasury purchases of $85 billion per month (QE3). It is arguable how successful it was but equity markets liked it and rallied to all-time highs. But the Fed can’t purchase $85 billion in Treasuries forever and yet it can’t cut it off cold turkey. The markets have grown too dependent on it. It needs to slowly wean the economy off of those purchases. The Fed needed to wait until economic conditions improved to the point that there was more organic demand for those Treasury instruments it was and continues to purchase. So this past December after two consecutive solid monthly employment reports and with Congress passing a budget it began the slow tapering process.

Since Fed Chairman Ben Bernanke first brought up the notion of tapering there has been hysteria over the inevitable tightening of interest rates. Some people confused tapering for tightening and some insist it is the same thing but it is not.

Will the fact that the Fed, or anybody for that matter, stop or reduce purchasing a large number ($10 billion) of anything affect the price of that product? Of course, and in this case the product is interest rates. So no tapering is not tightening but a reduction, and the eventual end of these purchases, will have an impact on interest rates. But it should not have the dramatic impact on interest rates that occurred in a panic this past spring.

Basically the Fed is saying the economy still sucks, it sucks so bad that we are going to keep interest rates at zero for at least another year but not so bad that in addition to keeping interest rates at zero we are going to continue to purchase $85 billion in Treasuries to help keep interest rates low. We are going to buy a little less. I don’t even know if it is fair to say that tapering represents a switch from an accommodative stance as the Fed will still be taking the extraordinary step of outright purchases of Treasury instruments. To say the Fed is moving away from accommodation usually means the next move would be a tightening but the next move is not a tightening, but rather to continue the extraordinary step of purchasing Treasury products, just not as much as the previous month. That step, that neutral stance won’t happen until QE3 is ended and the next step towards normalcy would be an actually increase in Fed Funds rate.

About the Author
Daniel P. Collins

Editor-in-Chief of Futures Magazine, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange. Dan joined Futures in 2001 and in 2005 he was promoted to Managing Editor, responsible for overseeing all the content that went into Futures and futuresmag.com. Dan’s incisive reporting and no-holds barred commentary places him among the most recognized national media figures covering futures, derivative trading and alternative investments.

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