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Last Wednesday the U.S. Federal Reserve surprised global markets by
deciding not to begin tapering its quantitative easing (QE) programs.
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).
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.
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.
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
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 too
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?
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.
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
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.
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.
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.
David Larock is an independent mortgage planner and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear weekly on this blog (movesmartly.com) and on his own blog integratedmortgageplanners.com/blog). Email Dave