Tapering – Join the dots and end up with ZIRP

In my opinion the Fed showed through its FOMC statement yesterday it has little control over events, something that should dawn on markets in the coming days. To debate this we must put aside the question as to whether or not quantitative easing is sensible in the first place and only focus on this FOMC compromise. There is an argument that any reduction in QE should be confined to purchases of Treasuries, because the budget deficit is reducing and the market probably needs more of this paper for collateral purposes. If that argument had been presented it would have made sense and the Fed’s stock would have likely soared. Instead the tapering is to be split between mortgage bonds and Treasuries, which suggests a “pluck a figure out of the air” approach rather than a more reasoned one. The scale of tapering is in the lower range of expectations, so presumably was intended to be market-neutral. This tells us that the FOMC probably came to its decision based on what was expected of it rather than from a sense of conviction that the policy is correct. But the greater inconsistency is over forward interest rate guidance.

When a central bank holds interest rates below their natural market level, it stands there to provide however much liquidity is required to keep the rate suppressed. This in practice is the result of a number of factors including overall demand for money, and on the supply side changes in the quantity of narrow money, bank credit expansion and required reserves. QE is one form of this liquidity, and the extent to which QE is reduced must be compensated for by other means if interest rates are going to be kept at the target level.

This simple fact makes changes in QE meaningless in the broader monetary context, and on this vital point the Fed keeps silent. Instead it attempts to offset the deflationary implications of tapering by increasing its commitment to zero interest rate policy (ZIRP) and for longer. We are left wondering how long it will be before this contradiction is generally understood. Furthermore, those that link QE to prospective prices for gold and silver are ignoring the commitment to interest rates and are effectively pushing a one-sided argument.

It is not just precious metals that are mispriced. Government bond yields, particularly for the weaker eurozone states do not reflect credit risk. Equity markets are priced on the back of ZIRP. Fixed assets, particularly housing and motor vehicles are being financed on the back of this unreality. The important point is not tapering, but that ZIRP continues indefinitely.