In a somewhat surprising move today, the Fed decided to begin the “tapering” process by decreasing the amount of bonds it buys each month to $75 billion from $85 billion. The consensus expectation had been for the Fed to defer this decision until its next meeting in late January. The market reaction to the news was somewhat surprising as well, with the Dow up 1.9% as I write. So what gives? Why are stocks reacting so positively to an event that had been so feared?
In my opinion, one of two things is likely going on here. The first possibility is that investors are encouraged to see that the Fed’s confidence in the economy has increased to such an extent that it felt confident enough to remove some of the stimulus. The second possibility is that investors are reacting to the strong Fed rhetoric that accompanied the decision to taper. This rhetoric included a forecast to (likely) “maintain the current target range for the federal funds rate (0 to 1/4 percent) well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.” This was a much stronger commitment than previous ones.
My suspicion is that the latter is more responsible for the stock rally than the former. Why? Because the yield on the 10-year is only up slightly compared to the level at the end of yesterday’s trading session. Clearly, bond investors (at least) are taking a sizable amount of solace in the Fed’s commitment to keep interest rates low for a long, long time. While we have no doubt that this is the Fed’s intention, there is certainly no guarantee that this will happen. If faced with an unanticipated surge in inflation in the months/years to come, there is little doubt that the Fed will act aggressively to contain the rise in prices. Alternatively, and just as importantly, there is a strong likelihood that the Fed will reverse today’s decision to taper if faced with economic weakening in the months to come. This brings us back to where we were prior to the Fed’s announcement today. The Fed’s actions will remain “data-dependent” with regard to both dovish AND hawkish monetary-policy decisions. The wildcard in the monetary policy equation is asset prices. How far will the Fed allow stock prices to rise before it becomes uncomfortable with the possibility of bubble formation?
The Fed’s move today does very little to change the current pace of economic recovery. The Fed continues to pursue policies that may place a floor on the pace of economic growth, but that will also put a ceiling on the recovery. In other words, the longer the economy remains heavily dependent on artificially low interest rates, the harder it will become to wean itself off the low interest rates. Therefore, in a perverse way we believe that the Fed’s aggressive monetary policy may actually be hurting our longer-term growth prospects. In avoiding a short burst of moderate pain for the economy, the Fed continues to opt for a prolonging of the economic pain.
We remain concerned that asset prices, such as stocks and houses, should be taken into consideration in the Fed’s determination of “inflation.” Had Chairman Greenspan considered the steep increase in housing prices, he would have been much less likely to keep interest rates so low for so long (which exacerbated the housing bubble). We continue to find the best value in high-quality companies with strong balance sheets. We will remain vigilant as we navigate through these very interesting times!