4 Reasons The Fed Delayed Tapering

Why did the Fed delay tapering of bond purchases?

Despite widespread expectations that the Federal Reserve would begin reducing the stimulus it provides the economy through quantitative easing, the central bank said yesterday that it will maintain its current pace of Treasury and mortgage bond purchases.

[BigTrends.com Analyst Editorial: Apart from the reasons discussed below, we've previously mentioned several times that the Fed has become more politicized recently and appears to have less backbone than in the past. With Bernanke's term ending soon, the likelihood of delaying tapering as long as possible was something we saw as a definite possibility, despite the market pricing in that it would begin now -- it takes will to turn off the buying spigot amid very tepid economic growth and an unfavorable political climate to do so. It does seem that the Fed has become more politicized (influenced by DC power politics, public opinion, CYA and partisanship) than it was in the past ... if so, this is unfortunate, but not surprising given the growing politicization of virtually every aspect of government. In the short term the markets will like the continued flow of funds, and the economy does likely still need boosts from low interest rates -- but over the very long-term one has to wonder how the continued fiscal immaturity (among all parties) will affect currency, interest rates, and the global economy in the years to come. -- Moby Waller, BigTrends.com]

Four possible reasons explain why the Fed decided to delay tapering the $85 billion-a-month program.

Fiscal policy. Uncertainty over a possible government shutdown later this year, conflict in Congress over the federal debt ceiling, and the possibility of additional government spending cuts and other austerity measures seems to be making the Fed nervous about doing anything that might add to the negative shock from fiscal policy. Fiscal policy makers have performed terribly over the course of the financial crisis, and the Fed is the only game in town. It can't take the risk of adding to the potential problems that fiscal policy might cause.

Inflation and unemployment. Inflation is too low and unemployment is too high. There are no signs of an acceleration in the labor market, and no signs that inflation expectations are moving above the Fed's long-run target. As a result, why do anything that might be construed as a negative shock?

The Fed is gun-shy. When the Fed first began talking about scaling back its bond purchases, it was surprised by the ensuing rise in long-term interest rates, corresponding slowdown in housing and stock market plunge. Just talking about tapering led to an unexpected spike in interest rates, and although it appears that tapering was priced into financial markets, why risk another surprise? Additional bond purchases are unlikely to do much good for the economy -- all that can be done has pretty much been done already. But there is potential for a negative reaction from markets, and with the lackluster recovery, fiscal policy worries and other economic concerns, why take a chance?

Capital flight from developing markets. As investors have anticipated rising yields due to the Fed potentially beginning to taper, capital has flowed from developing markets to the U.S. That has caused economic problems that could feed back into U.S. markets, making a slow recovery even slower.

Overall, while there isn't a lot to be gained from the Fed continuing the bond purchases. But there is potentially a lot to lose from miscalculating the markets' reaction to the onset of tapering. As the Fed said in its policy statement explaining its decision to keep the program intact, "the committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases."

So if the economic data look good between now and the Fed's next meeting in December, particularly job growth, we can expect the Fed to begin reducing the volume of asset purchases, perhaps by $5 billion to $20 billion a month. But if the numbers still look weak, a delay in tapering until January -- the central bank's last meeting before Chairman Ben Bernanke hands the reins over to a new Fed chair -- or even beyond is not out of the question.

Courtesy of Mark Thoma, marketwatch.com



