Sunday, October 20, 2013

Trick Rather than Treat? Why the Fed [SHOULD] Taper in October.

(Updated 10/31: indeed the Fed continued it's current bond-buying program. The market dropped, though. Right for the wrong reasons.)

Occasionally politics and the Federal Reserve intertwine, like on the eve of a Presidential election, a government shutdown, or the confirmation of a new Fed Chairwoman. So, here we are, mere days away from Yellen's confirmation hearings and a Fed board meeting. What, oh what, will the Fed do?

Considering the whole context, the Fed would be smart to start tapering its $85 billion (per month) bond buying program in October. Here's why:

1. In her confirmation hearings, Yellen will be questioned by Republicans about her 'easy money' philosophy. If the Fed plans to delay a taper until 2014, these questions will drag on and on and the confirmation hearing will be a painful snoozefest and will be used by certain Senators to do a little grandstanding. If the Fed tapers a little bit in October, these questions will be more easily dismissed. (And it doesn't matter how the market responds to the taper -- Yellen can say either, 'see, easy money is needed considering that the market tanked after a small taper', or 'see, I'm not about easy money, I am about the right amount of money, e.g. this taper that we just did successfully'.)

2. The Administration needs ammo in the upcoming budget negotiations with Republicans, and the  kind of ammo they want is: "see, government isn't that big, and we're making it smaller!"

3. The Fed almost tapered in September, but decided otherwise at the last minute, presumably to hedge against the government shutdown/default risks. As it turned out, the market didn't care much about these risks, and now the stock market is at a terrifying height.  Furthermore, Shiller just won the Nobel Prize (and Yellen's husband and Shiller are buddies), so it's hard to imagine that the Fed could stomach a stock market bubble for more than an instant.

4. The Administration has made it clear (and Republicans have too) that the government will not shut down in January.

5. The Fed likes surprises, e.g. last month.

6. The Fed knows how to get the data it needs. The shutdown isn't going to prevent it from managing the economy.

7. Delaying the taper means that the Fed might have to do a larger initial taper when it finally decides to do so, and a large initial taper doesn't seem like either Bernanke's or Yellen's style.

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