Welcome To The Twilight Zone; The Fed 'Tapers' And The 10-Year Rate Falls And Gold Rallies

by: Robert Wagner

The Fed started the "Taper" back on December 18th, 2013, and except for a brief initial rally, interest rates have been all downhill since then.

Gold on the other hand, after a brief correction, has done nothing but rally.

Do either of those two charts make any sense at all? The Fed stops buying bonds and rates FALL? The Fed stops or slows "printing all this money out of thin air" and gold RALLIES? Is this an episode of the Twilight Zone? Has the world gone mad?

In reality it makes total sense, and I predicted it before it happened. I've been writing a series of articles detailing how fiscal policy is the determining factor, not monetary policy.

In conclusion, because the current administration is following a Keynesian model it is highly unlikely that the US economy will recover at a pace necessary to unwind the "taper" in a timely manner. Going forward I would expect economic growth to be anemic, inflation to remain subdued and unemployment to remain stubbornly high, and maybe even increase as more and more of Obamacare is implemented. The persistently high unemployment will prevent the Fed from quickly implementing the "taper" and will delay any increases in interest rates.

I can understand why the Peter Schiffs and Ron Pauls of the world hate the Federal Reserve. They tell all their followers to buy gold and that the world is going to end back in 2011 when the Fed is "printing all this money out of thin air," and then gold collapses, and now when the Fed is "tapering" its "printing all this money out of thin air," gold rallies. Their model is completely backwards, but because of their political ideology, they are blind to the truth and will never take the time to fully understand how the system works. Like the believer of the Bitcoin, the anti-Fed crowd are driven by politics, not economics.

Just recently I wrote an article expressing concerns that some members of the Federal Reserve may actually be listening to its critics and bowing to political pressure.

The Anti-Fed crowd has been consistently wrong since 2008, and it should concern investors to see Fed Presidents taking about continuing or even accelerating the "Taper" without any real solid evidence of economic growth and hope of lower unemployment. Fed policy should lag economic recovery, not lead it. Higher rates now threaten very recovery low rates was intended to trigger.

Fortunately after Tuesday's comments by new chairwoman Janet Yellen, my fears are alleviated. My big source of concern was that the Federal Reserve was abandoning its unemployment objective, and would allow rates to increase before the economy was on sound footing.

It is the second half of that quote that gets me most concerned. You would have to be living on Mars to think the US unemployment rate is actually 6.7%. The labor force participation rate is hitting 35 year lows. If you include discouraged and under-employed workers the unemployment rate would be 13.8%. 1/6th of our Nation's workforce is either un or under-utilized, and some of the Fed Presidents are wanting to accelerate the "Taper?" Why? I just don't get it. What are the benefits? Silence a group of misguided critics?

Parts of Janet Yellen testimony Tuesday sounded as if she had read my article, and were designed to calm the fears it expressed. She even mentioned using a broader measure of unemployment like the U6 method discussed and linked in the above quote. Such common sense was welcomed by the market, as demonstrated by the DJ Industrials rallying over 200 points on her comments. Sorry Ron and Peter, it looks like your poor record is likely to continue.

What then is it that Ron and Peter just don't get? What critics of the Fed just don't get is that monetary policy is a passive tool, it is a supporting tool, it isn't a driver. Monetary policy is often described as "pushing on a string." Monetary policy is the tail of a dog, and fiscal policy is the dog. To understand the behavior of the tail, one must understand what is happening with the dog. By focusing on the "tail" and ignoring the dog, all you get is a bunch of random movements which lead you to recommending gold at its peak, and has you doubling up on its way down. There is a lack of understanding between the cause and effect. Monetary policy is the effect, fiscal policy is the cause.

Monetary policy is dictated by fiscal policy, so in order to understand and predict monetary policy one must understand fiscal policy. The Fed has gone so far as to outline a strategy on which to build a Fed model. The key is, monetary policy is dependent upon unemployment, and unemployment is dependent upon fiscal policy. Fiscal policy should be the focus of the anti-Fedder's attention, not the monetary policy.

As I pointed out in the comment section of this article regarding QE and Jobs, the question analysts are failing to ask is why isn't monetary policy working this time? Did the laws of economics suddenly change? No, the laws of economics haven't changed. Monetary policy has the same affect today as it has in the past, the difference being that no amount of monetary policy can compensate for failed fiscal policy. President Reagan inherited an absolute mess from Jimmy Carter, and the economy recovered, President Reagan had the crash of 1987, and the economy recovered, President Bush Sr. had the first mortgage crisis and Persian Gulf War and the economy recovered. President Clinton had his first 2 years, and then by "triangulating" and co-opting the Republican "Contract with America," the economy recovered. President Bush Jr. had the dotcom and corporate malfeasance crash and 911 and the economy recovered. Why then is this time different? That is the 800lb Gorilla in the living room, that is the question analysts fail to ask.

The problem the economy, and in turn the markets face, is that fiscal policy hasn't worked over the last 5 years, and without any dramatic changes going forward, it isn't likely to start working. It makes no sense to think fiscal policy will start working just because the Federal Reserve starts to "taper." Monetary policy is like the guy in an inflatable raft with a hole in it that keeps pumping to replace the air that is leaking out. His efforts will keep the boat afloat, but they will not get the boat moving in the direction of the near by island. Only once the fiscal policy patches the hole, raises the sail and puts the oars paddling will the boat make it to the island. Monetary policy keeps the boat afloat long enough to implement a fiscal policy that can get the boat to shore, it does not actually propel the boat to shore.

Another analogy is a car with a detached gas hose. By spraying primer into the carburetor the car will spit and sputter, but it won't be until someone re-connects the gas hose that the engine will be able to have a sustainable run. Monetary policy is the primer and fiscal policy is reconnecting the gas hose to a full tank of gas. Once again, spraying the primer may keep the engine running, but it won't be until after the gas hose is re-connected that the car will run on its own.

The last analogy is a mule that pulls a plow to prepare a field for planting. The mule prepares the field for growth, it does not produce the growth. If once the field is plowed and the seeds planted, the farmer chooses to use salt to fertilize the field, nothing will grow. Beating the mule won't make the seeds grow as long as salt is being used as fertilizer. You can start a campaign to "End the Mule," but as long as salt is being used to fertilize the field, nothing will grow. No amount of plowing and planting will make the seeds grow as long as salt is being used as fertilizer. Monetary policy is the mule and fiscal policy is the fertilizer, no amount of monetary policy can compensate for failed fiscal policy. Seeds will never grow in salt.

If you accept the thesis that fiscal policy drives monetary policy, and that monetary policy is a supportive policy not a driver, then it makes total sense why the "taper" has resulted in higher gold prices and lower interest rates. Those two counter intuitive observations demonstrate that the markets have zero faith in fiscal policy being able to support an economic recovery. The "taper" represents the Fed taking the economic "training wheels" off, and the markets' reactions are predicting a crash. That wouldn't happen if the Fed started to "taper" and the markets had confidence in the sustainability of the economic recovery. The problem is taxing, regulating and redistributing isn't a plan for economic growth. President Obama got elected vowing to destroy entire industries, and the industries he planned to replace them with have a 9 out of 10 chance of failing. President Obama's record on jobs is so awful even the labor unions are critical of him. To make matters worse, this is an election year, and a landslide victory by the Republicans could undo much of what little President Obama has done to create jobs.

In conclusion; in my opinion, the chances of the current fiscal policy resulting in a sustained economic recovery are slim to none. It hasn't worked in the last 5 years, and it isn't likely to start working in the future either. Taxing, regulating and redistributing isn't an economic growth policy. Never has been, never will be. Cuba represents over 50 years of that model, and they are worse off today than they were back in 1959, at least there cars were newer. If fiscal policy doesn't change, there will be no real decrease in unemployment, and if there is no real decrease in unemployment, it is unlikely that the Fed will continue the "taper" and if they do it will be counter-productive. In reality the "taper" should result in higher interest rates, high interest rates are contractionary. If the Fed does continue with the "taper" and rates do increase as intended, and there is no growth oriented fiscal policy in place, the economy will likely fall back into a recession. If that happens, the "taper" will be off, and the Fed will return to "printing all this money out of thin air." That is why the "taper" has resulted in lower interest rates and higher gold prices, the markets are discounting slower economic growth, the end of the "taper" and the return to QEfinity. If that happens, don't be upset with the Federal Reserve, demand a change to fiscal policy. That is the only way to return growth to the economy, one only needs to study economic history.

However, that growth was halted by a second severe downturn in 1937-38, when unemployment surged again to 19% (see chart). The fundamental cause of this second recession was an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy...Also important was an accidental switch to contractionary monetary policy. In 1936 the Federal Reserve began to worry about its "exit strategy". After several years of relatively loose monetary policy, American banks were holding large quantities of reserves in excess.

Disclaimer: This article is not an investment recommendation or solicitation. 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. Past performance is no guarantee of future results. For my full disclaimer and disclosure, click here.

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.