Is it time to “taper?” That is the question du jour on Wall Street and in economic circles — whether the Federal Reserve should start winding down the “quantitative easing” bond-buying program that has helped stimulate the economy.
Views are mixed. Several experts, say yes, it’s time. Others worry it could be too soon. Three of the four experts that Knowledge@Wharton interviewed said that although economic growth is far from robust, still lingering at less than 2%, the economy has improved and appears ready to return to normal — or perhaps a “new normal.”
“I would say you would need 3% [annualized GDP growth] for tapering to begin,” says Wharton finance professor Jeremy Siegel. “That’s not a slam dunk, but right now that is my median forecast. I think we are going to get 3%-plus for the third and fourth quarters. That’s going to lead to the tapering.”
Not everyone believes, however, that the Fed needs to move this soon. “I personally am surprised that they have started to talk about it with unemployment at 7.6%, and without a stronger economy,” says Wharton finance professor Krista Schwarz, who once worked on the Fed’s open market desk in New York. There is a case to be made, she notes, that the Fed ended some of its earlier stimulus programs too soon. “Hopefully, this isn’t them making the same mistake again.”
New Fed Leadership
The issue is front and center as U.S. President Barack Obama seeks a replacement for Federal Reserve Chairman Ben Bernanke, who will step down in January, leaving the next chairman to phase out the stimulus programs, which began in 2008. In the past week, speculation has centered on two candidates, Fed Vice Chairman Janet Yellen and former Treasury Secretary Lawrence Summers. Most experts think Yellen would taper slowly, to allow the programs more time to stimulate job growth. Summers is thought to favor a faster withdrawal, as he has been less enthusiastic about the Fed’s massive market intervention.
Though the Fed has engaged in a variety of efforts to shift the economy to a higher gear, the most prominent is the purchase of $85 billion a month in Treasury securities and mortgage-backed securities. This quantitative easing — now in the third phase, known as QE III — increased demand for those bonds, lifting their prices and driving down yields, which move in the opposite direction from prices. That has helped to reduce yields on long-term bonds of all types, and that has helped keep down interest rates on mortgages and other loans. Making it cheaper to borrow stimulates spending, helping the economy grow.
Bond buying began with QE I in late 2008, when the Fed had between $700 billion and $800 billion on its balance sheet. Now it has several times that, causing worries that Fed holdings distort the natural balance between supply and demand for these assets. Another concern is that unusually low interest rates, while a blessing to borrowers that stimulates spending, are tough on bank savers, pension funds and investors who count on interest income. And eventually, too much stimulus can spur inflation, though that has not happened so far. So, as the economy gets healthier, stimulus programs are brought to an end and interest rates are allowed to go up.
To return to a normal market governed by natural forces of supply and demand, the Fed must stop buying bonds, then begin selling those accumulated in its inventory, a process likely to take five to 10 years, according to Wharton finance professor Joao F. Gomes.
Eventually, the central bank will also allow short-term interest rates, such as the federal funds rate, to rise. Currently near zero, that rate is normally in the range of 3% or 4%. In June, Bernanke indicated that rate could be allowed to rise if inflation remains at 2% or less and unemployment falls to 6.5% from the current 7.6%. The Fed funds rate governs short-term lending between banks.
In several statements beginning in May, Bernanke has said tapering could begin in September with a drop in monthly purchases to $65 billion, and wrap up as early as summer 2014. But he has emphasized that the schedule will depend on economic growth. And because he is leaving, the course of tapering is uncertain, causing jitters on Wall Street.
Bernanke’s recent talk of tapering seems curious to Schwarz. From his earlier statements, she expected QE III to continue until unemployment had fallen further. “From the signals they sent around a year ago, it’s surprising that they’re in such a hurry to cut down their asset purchases,” she observes. “It borders on reneging.” Clearly, she adds, inflation is not yet a threat, so there’s no need to slow the economic rebound. One possible reason for the hurry, she says, is concern among some experts and politicians that the Fed’s holdings have just become too large.
Those assets have been earning interest, which is passed to the Treasury, helping to reduce deficits, with about $89 billion remitted in 2012. But the QE programs also involve the Fed paying interest to financial institutions that keep huge reserves with the agency. As interest rates rise, that interest cost will grow, and wipe out the Treasury payments.
“If the interest rate does rise, then they end up not being able to pass along anything to the Treasury for a few years,” Schwarz says. “That may be one of the things that have influenced their rush to end further expansion” of Fed holdings. Paying less to the Treasury should not be a concern at the Fed, she contends, because payments of this sort are not part of the Fed’s mandate, merely a welcome byproduct of an extraordinary program.
U.S. economic growth has been stuck below 2% — low enough, some economists think, to justify continuing the Fed’s stimulus efforts. But Siegel and many others believe faster growth is coming. While many experts think the Fed will to start to raise the Fed funds rate in early 2015, Siegel thinks the economy will grow strongly enough to bring that move sooner.
Mark Zandi, founder of Moody’s Economy.com, expects tapering to begin late this year. “At that point, the economy should have navigated through the fiscal headwinds that it’s in the middle of right now — the tax increases and spending cuts — and growth should be picking up steam. Most notably, that should show up as more job growth and lower unemployment.”
Tapering is likely to finish “sometime next spring,” Zandi notes, and raising of the Fed funds rate will probably begin about a year later, when unemployment has fallen to 6.5%, with the funds rate eventually going to about 4%. “We get to Nirvana sometime, probably, in 2016 or early 2017,” he adds, describing a healthy economy. “It’s a long road back, almost a decade.”
Go Slow, Stay Flexible
All of the experts that Knowledge@Wharton interviewed say the Fed should stay flexible, and willing to slow the pace of tapering if economic growth does not accelerate fast enough. At the same time, they note, the Fed can help calm the markets by stating as clearly as possible what growth and unemployment targets must be met before bond purchases are cut to the next level. “I think it would be really helpful if the Fed lays down the conditions,” Gomes says, adding: “Bernanke is in his last few months on the job, so it’s unavoidable that we have some uncertainty. It’s a shame.”
Siegel believes the Fed’s first step should be to reduce monthly bond purchases to some $65 billion to $70 billion from the current $85 billion. Further reductions would reduce purchases in $10 billion to $15 billion increments, reaching zero sometime in the spring of 2014.
Among the issues the Fed must deal with is just how to talk about tapering, as the financial markets have become sensitive to the issue. Stocks plunged by more than 4% in June after Bernanke suggested interest rates would be allowed to rise. Many investors and market experts believe the low-rate policies have helped lift stock prices by making bonds less appealing as an alternative, and by reducing corporate borrowing costs, which improves earnings. “This has been an amazing program from the point of view of stock-market investors,” says Gomes. “It’s been magnificent.”
Siegel adds, though, that many investors give quantitative easing too big a role in stock gains. “The market is, in my opinion, way too fixated on this quantitative easing as being the cause of the increase in [stock prices], so they think that once this quantitative easing is over the market will fall back. I think that’s wrong.” Zandi, too, believes stocks can continue rising amid tapering. “Investors will be balancing the negative of higher interest rates against the positive of a stronger economy and stronger growth,” he says. Rising interest rates are not likely to hurt stocks if corporate earnings are going up at the same time, adds Gomes. “When you put the two things together, I think it will be neutral.”
Federal Reserve policies during and after the financial crisis have been controversial, with many conservatives believing the Fed tinkered too much with free markets, while many liberals think the stimulus programs should have been even more aggressive. The Fed and Bernanke, says Siegel, deserve an “A” for the range of policies, which included guaranteeing credit for the financial system, protections for certain types of assets, protecting deposits and the solvency of money market funds.
“I think quantitative easing, although it received a lot of criticism, was important in terms of speeding the U.S. recovery,” Siegel says. “The fact that the U.S. and the developed world have been leading the recovery [worldwide] is due to Ben Bernanke’s policies.” Zandi concurs: “I think all the criticisms that have been lobbed at their extraordinary actions, including quantitative easing, have really fallen flat.”
“Bernanke, and everybody at the Fed, were given a pretty tough exam,” says Gomes, “and they probably got 75% or 80% right.” The key, he says, was a willingness to keep trying new things, many of them untested. That contrasts with a rigidity that until very recently has kept Japan mired in economic doldrums for more than a decade. “You have to be open minded and throw out the playbook.”
Still, a few unknowns linger as the next set of policies replaces the last. Among them: Will interest rates and inflation settle into a “new normal” — a range different from the past? Schwarz believes the 10-year Treasury note, currently yielding about 2.7%, could settle at a new normal around 4%, a tad lower than the 4.5% generally considered normal in the past. Siegel believes yields and inflation will both be lower in the future then they were, on average, in the two or three decades before the financial crisis.
Zandi agrees. But he also expects stock gains will be more modest than they were before the financial crisis. In the latter decades of the 20th century, prices of stocks, bonds and homes were driven up by the gradual decline in interest rates, a condition that is not likely to be repeated in the near future, he notes. With the falling-rate factor removed, stock gains will rely on economic growth, which drives profit growth, leading to annual returns perhaps averaging 5% instead of 10%. “Asset returns have been quite strong — extraordinary, really — but those days are over.”