Taper Vs. No Taper - Let's Meet Somewhere In The Middle

by: John Rothe

To Taper or Not To Taper...

Volatility in the US equity and bond markets has risen since Ben Bernanke and the rest of the Federal Reserve Board mentioned the possibility of tapering its bond purchase program - in other words, a potential end to the "free ride" the Fed has been giving investors.

However, economic data is still weak and a reduction in economic stimulus by the Fed may harm the US economy.

The Fed Mandate

In 1977, Congress amended The Federal Reserve Act, stating the monetary policy objectives of the Federal Reserve as:

"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."

Fed projections (provided by the Federal Reserve Bank of Chicago) show future target rates for inflation and employment rising, and gives the Fed a compelling reason to slow down its stimulus program by tapering the purchase of US bonds in order to keep long-term interest rates low.

However, current economic data show that the projections may be a bit optimistic.

Weak Economic Data Continues

Last week's unemployment number declined to 7.3%, continuing a downward trend in unemployment since 2011:

Source: Bureau of Labor and Statistics

The problem the Fed is facing, however, is the actual unemployment rate may be much higher than what the "official" rate shows.

Job creation, year to date, remains lower than in 2012. In 2012, a monthly average of 182,000 new jobs were created. In 2013, the average has dropped slightly to 180,000 jobs per month.

In fact, the actual cause of the drop in unemployment may not be that more people are finding work, but that more people are giving up.

The participation rate in the labor force continues to drop (those who are not actively looking for work are not labeled as unemployed):

Source: Washington Post, BLS

Popping The Bubbles Before They Get Too Big

The question facing investors is if the employment picture is not really improving, then why would the Fed slow down its stimulus program?

The Fed may be worried about future inflation spikes caused by bubbles forming in the economy due to a perception of risk-free money - for example in the US stock market.

Investors continue to drive the stock market to record highs despite any real growth in corporate earnings. The idea that the Fed will continue to put an ever rising floor on equity prices has created a perceived environment of practically risk-less investing.

Source: John Mauldin

This environment has allowed stock market multiples to expand dramatically without any real earnings growth.

Variable Taper/Purchase

Going forward we may see the Fed try to keep investors more on their toes by introducing a more "variable" taper/purchase program.

The average annual amount purchased by the Fed may remain the same (only time will tell), but we may see Bernanke and company start to adjust purchase amounts more frequently - thus giving the illusion of tapering without damaging the fragile US economy.

By adding this element of the unknown, the Fed may be hoping to remove the perception of risk-less investing in equities and any other bubbles that may be forming in the US economy.

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. I have no business relationship with any company whose stock is mentioned in this article.