(Lack Of) Inflation Killed The Taper

by: Modeled Behavior

By Karl Smith

The Federal Reserve shocked the markets this afternoon by deciding not to reduce its monthly purchases of mortgage-backed securities and long-dated U.S. Treasury bonds. The taper -- as the reduction was known -- was widely anticipated and feared among on Wall Street and the surprise announcement sent stocks and bonds soaring.

The Good

In the immediate term, any concern that Wall Street might have had over the Fed's commitment to keeping interest rates low has been erased. The taper is just the first step in a long process that culminates in the Fed raising interest rates. The fact that the Fed is not even willing to take that first step, after the market had expected and accepted it, demonstrates the Federal Reserve's resolve over low interest rates. It might seem that raising interest rates is the "tougher" position because low interest rates contribute to rising stock and bond purchases, as well as easy financing for businesses and consumers.

However, precisely because of that fact central banks like the Federal Reserve face enormous pressure from bureaucratic community worldwide to raise interest rates early. It not much of a stretch to say that a central banker who is late to raise rates is afraid of being called a wimp, a lapdog, or a useless pushover by his or her fellow central bankers, staff economists, and international economics organizations, like the IMF. As a result, economies -- most notably Japan after the 1989 bubble-crash -- languish for years because the central bank raises interest rates at the first sign of a full recovery.

The Bad

Unfortunately, this move underscores fears that -- in defiance of its congressional mandate -- the Federal Reserve is far more concerned about inflation far than unemployment. The economic projections the Fed offered to help explain its surprise decision showed that inflation is running lower than the Fed expected in June, and is likely to continue to do so throughout 2014. On the other hand, unemployment is doing, if anything, mildly better than expected.

Rising inflation and low unemployment are characteristic of an overheating economy. Hence, lower-than-expected inflation helps remove concern that the Fed is keeping interest rates too low. On the other hand, low unemployment does the opposite. The Fed's shocking departure from the expected came at a time of surprising low inflation, while periods' similar surprisingly high unemployment rarely produced similar reactions.

In particular, unemployment has been way above the Fed's unofficial target (5.5%) since the beginning of the Great Recession in the winter of 2007/2008. One might expect that, given this, the Fed would be willing to risk extra stimulus even if inflation was a bit above its quasi-official target of 2%. On the contrary, the Fed has typically waited until inflation forecasts fell below 2% before increasing the amount of stimulus.

The Fascinating

There is going to be plenty for Main Street and Wall Street to focus on in the wake of this announcement. Stocks and bonds are surging. Interest rates -- including mortgage rates -- are falling. For geeks, however, the possibly more significant outcome is that the Fed took a major step toward the rationalist ideal -- an organization that responds dispassionately and predictably to changing data. This is in contrast to the mystical ideal promoted Alan Greenspan, in which the Fed guides markets with deliberately confusing statements and opaque policy moves designed to make it seem omnipotent.