Yesterday’s surprise move by the Fed to announce a $10 billion reduction in their monthly bond buying program, from $85 billion to $75 billion, was accompanied by a commitment to maintain 0% short rates indefinitely. This was a significant policy shift from the previously stated target of 6.5% unemployment, after which rates were to begin to rise. This added announcement on short-term interest rates served to offset (and then some) any possible negative reaction due to the tapering announcement. Stocks responded exactly as Bernanke and the rest of the FOMC had hoped, with a gain of almost 300 points on the Dow, and new all-time highs for both the Dow and S&P 500.
As positive as this reaction was, it was a single day event. Now we must get back to reality. Despite what the Fed said it intends to do today, the reality is that they will be forced to raise rates if inflation heats up. Yes, I know, if anything we are in a deflationary environment today. It is difficult to contemplate a threat from inflation right now, or even for the foreseeable future. But this is the point – it is virtually impossible for the Fed or any of the rest of us to anticipate when or if inflation will become an issue.
What is of more concern to me in the shorter-term is the very real threat of a steepening of the yield curve. If the Fed continues to hold short rates at 0% and they taper-off their bond buying program (which will start next month), long rates will increase (they are fast approaching 3% for the 10-year treasury right now). As long rates rise, and the Fed holds short rates at 0%, the yield curve will have an increasing slope, meaning the yield curve will steepen. A steepening yield curve is highly detrimental to longer maturity bond prices, and will also make borrowing money over longer periods of time for corporations and individuals alike more difficult and more expensive. This would not be a good environment for fostering economic growth.
Another fundamental problem with the Fed’s quantitative easing (QE) strategy of buying all these bonds ($85 billion each month since September of 2012) is that, once interest rates begin to rise, the value of the bonds they have purchased will decrease. This means that, in the future, should the Fed want to reduce their balance sheet meaning sell some of these bonds, they (we the American people) are going to take a loss. The higher long-term interest rates rise, the large the loss will be, unless they intend to hold all of these bonds until maturity. Trying to unwind these positions before maturity will very likely result in massive losses as well as a constriction of liquidity in the economy – just as the Fed used buying bonds to flood the economy with loose cash, if they try to sell bonds, they will be sucking cash out of the economy.
Unwinding all of the financial engineering that the Fed has been using during the recession and slow recovery we have experienced since 2008 has always been a concern for me. We are in uncharted waters, since the Fed has never before used QE to this extent. Frankly they don’t know how things are going to end. As with any situation with multiple variables, the Fed will need a perfect storm of outcomes with all economic variables working exactly as they need them to, for us to get out of this situation without experiencing severe economic problems. I have my doubts as to the likelihood of this outcome.