The Fed keeps the insane party going and why this is bad news for (nearly) all of us

By Neil Patrick

Investors have been stressing since the spring about the autumn prospect of Ben Bernanke printing just a few dollars less than before. Whole economies, like India, have wobbled before the threat that the Fed might print ‘just’ $75bn a month instead of $85bn.

And just as they were getting used to the idea, he goes and bails out at the last minute. This astonished almost everyone.What is going on?

Is this what Bernanke wants to leave behind?

I don’t wish to sound smug, but I wasn't as surprised as some people by this latest Fed stunt.

Why? Well primarily because the U.S. economy remains so weak that there are serious risks in actually initiating this move. Of course, the time must come when the Fed will begin to reduce its dollar printing. It seemed fair to assume that with all the advance warnings, the markets had already priced it in. And so I suspected the Fed might be much less aggressive than almost everyone anticipated.

But you can easily argue that the financial markets have become so accustomed to the Fed’s easy money policy that the quantitative easing (QE) addiction is now seriously ingrained. In other words, the stock market has consumed so much booze that the hangover will be so severe that it’s really preferable (not to say easier) to stay drunk.

However, I did think they would at least do something. After all, the market has been given so long to get used to this idea.

If the Fed actually ever intends to stop printing money, now looked a good time to make at least a small gesture in that direction. Even a 'tiny' reduction of $5bn would not have upset the markets too much, and would start getting them used to a slightly more sober environment with just a little less QE.

But no. Even with US stock markets at a record high, $5bn was too much for Bernanke. The Fed will keep printing $85bn a month…for now. And there’s no obvious prospect of this changing before the end of the year.

Markets were both stunned and cheered. Hurrah…even more free money! Gold soared. Emerging markets jumped, developed markets too. Pretty much everything jumped except the US dollar.

The Fed provided a few excuses for its inaction. It doesn't like the fact that bond yields have jumped so quickly in recent months. It’s worried about the impact of this on the housing recovery. And there’s also the threat of another big crisis over government spending, as the debt ceiling hovers ever closer.

As Paul Ashworth of Capital Economics pointed out, the Fed is probably “also increasingly concerned… that Congress could trigger a Federal shutdown within the next month.”

But if Ben’s really worried about the politicians not getting their fingers out to try and agree on something, then he should take away the security blanket of less QE. As Heidi Moore noted yesterday, he should “force the economy, the markets and Congress to think for themselves.”

So it’s all a load of shabby excuses. If this proves anything, it’s that Ben Bernanke doesn’t want to be remembered as the man who pulled the plug on the recovery too early, plunging the US into the Great Depression of the 2010s.

I guess he’d rather risk being remembered as the guy who acted too late to prevent the Hyperinflationary Collapse of the 2020s…

So what can we expect to see now?

It seems reasonable to assume from this that when it eventually happens, the actual process of tapering will be slow and gradual with the goal of minimizing any potential market disruptions.

But this is exactly where the difficulty lies. After all, everyone knows that the Fed cannot continue expanding the money supply at the current rate. Therefore, the challenge is how to taper with the least amount of market disruption.

I suspect this will include an increase in market ‘signals’ from the Fed to gauge the market’s reaction to various possible Fed actions and having contingency plans in place to try to control any unforeseen reactions and consequences which arise.

Tapering will mean higher interest rates

Most believe that tapering will result in an increase in interest rates, especially at the higher risk end of the market (like your mortgage, especially if it’s large or your earnings and credit history are anything less than dazzling). So, in this scenario, the housing market recovery could be stopped dead in its tracks.

Some claim that the delay on the part of the Fed may be politically motivated as it helps the Democrats by keeping interest rates low. Only a few people actually know the truth. The rest of us are left to speculate.

So, if the Fed does eventually get around to tapering, interest rates rise, the housing market recovery stalls, and the federal government deficit and debt spike, at election time, the Republicans will surely have all fingers pointed at the Democrats.

However, since the Republicans couldn't pull off victory in the last presidential election when the unemployment rate was at 8.2%, and given that Obama was the first incumbent in the modern era to be re-elected when the unemployment rate was above 8.0%, I’m not convinced that the Republicans would automatically benefit.

But the fact remains that higher interest rates will hurt everyone. Everyone that is except investors who rely on interest income.


So what does all this mean for most of us?

Even when the Fed does eventually begin to taper, I think they will remain “highly accommodative.” In other words, they will not raise short-term interest rates sharply for quite some time. Recently, when the Fed merely hinted that they might begin to taper, stocks sold off sharply.

So when will the Fed begin to taper? Some say December, but that’s during the holiday season, a period when the economy typically sees a brief uplift. This seasonality makes it difficult to determine if the economy is really healing or just experiencing a Christmas boost. Therefore, even though it’s possible the Fed will taper later this year, I don’t believe they will until at least 2014.

Despite the fact that many U.S. stock markets are reaching record highs, investors need to have a plan in place to protect themselves against a very possible and very nasty collapse. We are a long way from being out of the woods yet. In the interim, with GDP under 2.0%, stock values are continuing with their unwarranted inflation and I think the prospect of a severe correction in equity values just keeps on getting more and more frightening.

So investors need to keep a sharp eye on their assets and protect them against the very real threat of a severe market correction. Keep in mind that at some point, the Fed must take away the punch bowl, the party will end, and the probability of a collapse in not just stock values but other asset classes too is high. Really high.



What does this mean for investments, jobs and your financial future?

If you are an investor, hold your course. If you were happy with what you were doing before the 'vapor taper', you’ll be fairly pleased this week – almost everything you own has gone up in value (for now). Cheap Eurozone stocks still look good, Japan is still doing the business, and if you still have any, you should hang on to gold, specifically as a hedge against the real risk of systemic collapse which hasn't retreated from view.

But I wouldn't expect an easy ride in the coming months. Once the delusional euphoria of ‘QE forever’ wears off, there are going to be a lot of confused investors in the markets. As Eric Green at TD Securities told the FT: “The Fed had the market precisely where it needed to be.” This delay ” “ultimately makes that first step in the tapering process harder to achieve.(My emphasis)

It also puts a lot of pressure on Mark Carney at the Bank of England. On the one hand, Mr Carney will be pleased. The Fed’s 'vapor taper' might take some of the pressure off global interest rates in the short term. On the other hand, the slump in the dollar has pushed sterling higher. Carney won’t be too happy about that.

Anyway, what does this all mean for the outlook for most of us? Not investors with big investment portfolios but people with normal jobs and normal financial commitments. You probably know what I’m going to say.

The impact of this for business and hence jobs is hardly encouraging. The outlook for federal sector employment remains bleak and only confident growth in the private sector can offset this. But whilst share prices continue to inflate, significant GDP growth and business confidence remain elusive. So while growth in earnings remains subdued, employers will remain cautious about increasing workforce overheads.

We are likely to see a continued expansion of all the things employees dread like short term contracts, outsourcing, cut backs on management and support teams, in other words, growth in low paid, short term jobs, but contraction of secure, well paid jobs.

So we can all expect our basic costs of living to keep on rising at a scary rate amidst a really tough job market. And as I've talked about previously, slashing our outgoings, reducing our borrowings and increasing our income level through the acquisition of income generating assets is now more important than ever.

The crazy Fed party will end soon hopefully with a whimper not a bang.