A reader asks, “what is tapering and why does it matter?”
Part 1 of 2, Series on Tapering groupthink
Tapering will definitely and significantly affect markets and quite possibly your investments. Tapering refers to the anticipated reduction, lessening or easing of the economic stimulus.
The economic stimulus is the vast amount of money the U.S. Government pumps into the American bond market each month to spur the economy. That stimulus indirectly supports all financial markets.
Notice of change
The first talk of tapering landed with an enormous and unwelcome thud on May 22, 2013. What a party pooper! We were having a ball at the never ending equity gala when the host says the bar may get closed!
The equity party had been going along just fine. Prices were rising and everybody was making money. What could possibly go wrong!? Then the guy with the key to the wine cellar starts taking about taking the punch bowl away! Careful of your reaction, tapering groupthink may cost you!
Equity markets around the world have greatly benefited from the massive stimulus provided by the U.S. Federal Reserve Bank. Their gargantuan bond-buying program, known as quantitative easing (QE) supported the mortgage market.
In essence the Fed used their central bank money creating power to issue $85 billion in credit each month. The credit was immediately directed to the bond market to purchase mortgage backed securities.
Housing back from the brink
The on-going purchase of mortgage backed securities puts the money to work supporting housing. Mortgage backed securities provide funding for the mortgage market. Funding mortgages lets people buy houses.
The 2008 financial crisis immediately cascaded into and stopped the entire mortgage market. No refinancing or new mortgages were available. At any price! Without action house sales would stop and the economy would plunge into a depressionary freeze.
The U.S. Fed stepped in and created the QE program. That effectively funds millions of mortgages. As a result, a stalled house construction industry restarted, existing houses could again be refinanced and people could buy and sell houses.
When the housing market works, the economy works. The American economy moved back from the brink of collapse. Then over time a positive, although slow improvement begun to take hold. As the American market improved the positive effects flowed to markets around the world.
But here comes the but
The immediate financial and economic crisis was averted, but…you know there always has to be a but! Money creation can’t continue unabated forever. Somebody has to pay the bill and balance the books. To work properly, in normal circumstances, capital markets fund economic development and growth.
Governments can create money and stimulate an economy, a region or an industry, for a period of time. Providing the stimulus produces positive economic results.
In balance, or on the other side of the money creation equation, are equal amounts of debt or inflation. Either, or both can spell big trouble for a society or an economy.
When capital markets fail, as in 2008, governments can step in as a last resort. However, as sure as the law of gravity affects us all, nations and governments are subject to economic laws. Stimulus programs have to function within finite economic limits.
Good governments accept economic limits
Responsible governments let economic and job growth set those limits. In theory, governments can create money for economic stimulus. Providing the money gets used to spur significant growth, within a reasonable time.
New economic activity and job growth promises to generate more contributing taxpayers. New taxes and growing economic activity returns significantly more than enough revenue to cover the initial cost of the stimulus. In such a scenario everybody wins!
However, when job or economic growth does not happen, or is insufficient, trouble looms. The money creation process produces national debt and often massive inflation. Then a bad economic situation can becomes much worse yet. Witness the growing economic mess and 50% inflation in Argentina as an example of what not to do.
QE must end
Even the most successful stimulus programs must come to an end. For anyone taking a longer view on the economy, the sooner the better. All market players know the day to end QE must come. But as we humans often do, later always seems like the better time.
Fed Chairman Ben Bernanke is well aware of the need to end QE. The economy continues to improve. And now we have begun to see the first signs of further acceleration. The brilliant Fed Chairman knows we need to be reminded that things are going to change.
So he gave notice. He clearly indicated the QE program would ease or taper. He wants the market ready in advance so there is ample time to adjust. He reiterated that the change would be gradual, thus his reference to tapering support rather than a rapid, complete or immediate stop.
Further, the tapering would only begin after the Fed was satisfied the economic improvements were in place and could be expected to continue. That is important. He said in place and expected to continue. This was advanced notice of what would be expected to come but not imminent.
The stock market responds
Naturally, the market did what is always does – overreact! Like spoiled children reminded that bedtime was coming there was a bit of a hissy fit! Tapering groupthink in action!
Immediately the market was hit by sharply falling prices as some anxious sorts ran for the exits. Think before doing is a good idea but at times those that do, well, they just do. They sold mindlessly and prices dropped.
Fast forward until today and the markets fully recovered and are higher than ever! So far no QE tapering. Next time we will continue discussing QE and tapering. We can explore just what it all means, how to prepare and what you should to do in response.
Does the promise of tapering concern you? Make a comment, ask a question, we can talk about it.
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White Top Investor
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