3-Pitfalls To Fed's Tapering
Had a good discussion yesterday with Greg Robb at WSJ Marketwatch discussing various pitfalls that the Fed will face when trying to slow injections of stimulus into the financial markets. The article below is from Greg and he did a nice job coverting the issue. However, one pitfall that I think is missing is the inherent "liquidity trap" that as I discussed previously (see here and here) could wind up being a much larger issue than anticipated in the not so distant future.
It has become fairly clear after all of the talk and turbulence surrounding the Federal Reserve's policy meeting that the central bank wants to pull back on its easy policy stance if it can.
"Market participants have come to accept that the Fed is not going to purchase securities ad infinitum and that the wind-down process will probably be implemented later this year," said Ward McCarthy, chief financial economist at Jefferies & Co.
As the Fed starts its two-day meeting, questions arise over how the Fed should handle tapering its quantitative-easing program and what's in store.
Odds that the Fed would increase the size of its $85 billion-a-month asset purchase plan are now seen as very low. Read preview of Fed's meeting.
But there are a few potential pitfalls that could damage the economy and force the central bank to reverse course, some analysts say. Here are three of them: debt ceiling, deflation and a spooked market.
The last stand-off between congressional Republicans and the White House over the debt ceiling in 2011 sent stocks down 20% and pushed down GDP growth by almost a full percentage point, noted Lance Roberts, chief economist of Street Talk Advisors in Houston.
So it is hard to imagine that the Fed will reduce the pace of purchases, "at least not going into" the next debate on the debt ceiling this fall, he said.
Recent good news on the deficit has pushed the timing of this year's debt ceiling clash into October, before a rough deadline in November, said Sean West, head of Eurasia Group's U.S. practice.
Despite some rough talk expected over the summer, the conventional wisdom is that the two sides will avoid a default or a crisis.
"Both parties have signaled that they see little benefit in actually playing chicken with the debt ceiling, though both sides will play hard ball in advance of the deadline, West said.
"This has the lowest potential for a meltdown," West added.
With the conventional wisdom not expecting a show down, any hardening of attitudes as the deadline gets closer could be a "negative surprise," West said. So it would be a "negative surprise" if the risks of no deal rise in September, he noted.
Inflation remains below the Fed's 2% target.
The core consumer price index is up just 1.7% year-on-year in May. The central bank's preferred measure, the index for personal consumption expenditures, is up only 0.7%.
Economists disagree about the causes of the low-inflation trend, which has been in place since the Fed started its latest bond-buying program last September. Some think inflation will bounce back later this year, others are not so sure.
St. Louis Fed President James Bullard has said that low inflation has been a surprise and can allow the Fed to keep up QE3.
McCarthy of Jefferies said that the Fed might actually have to increase the pace of purchases to combat low inflation.
One last worry is that the Fed will spook markets with discussion about how fast it might exit from its ultra-easy policy stance.
"Another banana peel is the Fed might tell the market too much and panic the market into a bigger selloff," said Roberts of Street Talk. "The QE rally could come to a quick and sharp end," Roberts said. Consumer confidence would deflate, which could dampen growth, he added.