Fiscal Policy Clearly Driving Monetary Policy, Expect Long Drawn Out Taper

Includes: EEM, GLD, SLV
by: Robert Wagner

For the last few months I've been writing articles to help investors form their expectations for the Fed's "taper." One article titled " Expect A Long, Slow, Gradual, Uneven Taper: Macro Economic Fiscal Policy Isn't Working" detailed how failed fiscal policy would likely result in the "taper" taking much longer than the market was expecting. Yesterday's Fed decision to do nothing makes me more confident in that theory than ever. Prior to the Fed releasing its comments yesterday I wrote an article detailing what I expected would be the market' reaction, which all turned out to be effectively correct:

If the Fed's guidance is that the economy is still struggling, expect equity markets to rally...If the Fed's guidance is that the economy is still struggling, expect bond markets to rally...If the Fed's guidance is that the economy is still struggling, expect the gold and silver markets to the short-term.

The one thing I did not do however and now regret is to make a bold prediction as to what I expected the Fed was likely to do like fellow Seeking Alpha author Steve Nicastro did in his article titled "There's No Way In Hell The Fed Will Taper." The facts are, if the Fed is truly "data driven," then we are going to have a very long "taper." Yesterday's decision not to act should dispel any concerns that the Fed is bowing to political pressure, and that the Fed may do something for political reasons that is contrary to its stated objectives of lowering unemployment, stimulating growth and slightly boosting inflation.

Looking forward, this article details the likely steps the Fed will take toward recovery. Yesterday's decision pretty much proves that in order to understand the Fed's monetary policy, investors must understand fiscal policy, and as yesterday proves, fiscal policy isn't performing in a manner that will allow the Fed to implement the "taper."

The one thing not covered in the video is the real reason for the slow economic growth, contractionary fiscal policy. There is nothing monetary policy can do to compensate for failed fiscal policy. If investors want to understand what the Fed will do, they should study the progress in fiscal policy. Fiscal policy drives monetary policy, and until Washington gets its act together, Mr. Bernanke's hands are tied, and highly accommodative monetary policy can be expected to continue.

The problem this creates for investors is that the impact of fiscal policy is infinitely more complex to discount and analyze than monetary policy is. Whereas monetary policy has relatively consistent and predictable impacts on the markets, fiscal policy isn't so easy to read. Lower interest rates impacts all industries in a relatively similar and predictable way. Fiscal policy however often harms one industry at the expense of another like the EPA's RFS2 program benefits biofuels companies at the expense of the "Big Oil" companies and tax code changes can impact certain industries more than others and healthcare law changes can trigger hiring freezes and earnings uncertainty.

Case in point is how the Fed is likely to delay ending its mortgage buying program because of fear that it may adversely harm the housing market. Fiscal policy shows no such concern for jobs when huge job creating opportunities like the Keystone Pipeline are blocked, Obamacare results in employers cutting back hours to avoid having to pay for healthcare and fears of a government shutdown create paralyzing uncertainty. Unemployment is likely the deciding factor for the Fed, and without lower unemployment, there is no basis for the Fed to aggressively implement the "taper."

What then should investors do if understanding fiscal policy is so complex? On a micro level, investors should understand the impact fiscal policy is likely to have on a specific industry. If for instance an investor is invested in the biofuels industry, they should be concerned with any changes with the EPA's RFS2 program. On a macro level investors should understand the impact fiscal policy will have on the unemployment rate, inflation rate and the growth rate of the economy. Those metrics will ultimately determine monetary policy, and be drivers behind any sustainable market move.

The problem I see going forward, and why the "taper" will likely be delayed and extended, is that fiscal policy is working counter to the objectives of monetary policy. The Fed can't implement the "taper" until fiscal policy is supporting of lower unemployment and higher inflation. The other problem is that while unemployment and inflation do appear to be slightly improving on the surface, the headline numbers are highly misleading, and the Fed knows to look deeper into the numbers and not just accept the print number. Unemployment has been improving, but it has been improving for all the wrong reasons. The unemployment rate hasn't been dropping because more jobs being created, it is dropping because job seekers are losing hope and falling out of the labor force. Inflation isn't creeping up because of strong, robust and sustainable increases in demand, usually the result on low unemployment and increasing real wages, inflation is increasing because of unrest in the Middle East and supply decreasing, price increasing policies like the EPA's RFS2 that consumes around 40% of corn production that drives up food and energy prices.

In conclusion, yesterday provides undeniable proof of how important it is for investors to understand how fiscal policy impacts monetary policy and in turn the markets. The investment strategy for a rapid "taper" is different from the investment strategy for a slow, gradual, uneven and delayed "taper." If my theory is correct, and the "taper" is far from its end point, or even from beginning, QE should continue, providing support for homebuilders, gold/SPDR Gold Trust (NYSEARCA:GLD), silver/iShares Silver Trust (NYSEARCA:SLV) and a weakening US Dollar may help the emerging markets/iShares MSCI Emerging Markets (NYSEARCA:EEM). That support however will only be temporary. The "taper" will eventually be implemented. Delaying and slowing the implementation of the "taper" doesn't mean the day of reckoning has been permanently erased, it has simply been rescheduled to a later date.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.