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.

Is Performance Becoming Reality? Washington Channels Mickey Rourke.

The Hazard of Fighting over the Deck Chairs as the Ship Sinks

The lively performance this year of that theater of the absurd classic "The Annual Federal Budget Negotiations" has captured our attention while the more nebulous (yet potentially catastrophic) event, the default of the U.S. government on its debt, is looming ever closer. The so-called debt ceiling is a self-inflicted limit (see excerpt of Treasury Secretary Lew's October 1 letter to Congressional leaders  below). In any case, if the bankruptcy of Lehman taught us anything it is that the world is a lot more connected than we expect it to be. For an overview of the possible fallout: https://www.dws-investments.com/EN/docs/research/I-32798-1_Government_Shutdown_Risk_and_Debt.pdf

CBO and other agencies and analysts estimate that the Treasury could have until Halloween before the ceiling is hit but the default occurs when the Secretary and the President say it does.

October 1, 2013
I am writing to follow up on my previous letters regarding the Department of the Treasury's responsibility to finance the government and to protect the full faith and credit of the United States. In May of this year, the U.S. government reached the statutory debt limit, and Treasury began taking certain extraordinary measures to be able to continue, on a temporary basis, to pay the nation's bills. Today, I am writing to inform Congress that as of today Treasury has begun using the final extraordinary measures. There are no other legal and prudent options to extend the nation's borrowing authority. The impact of these measures was incorporated into the forecast that I shared with you last week, and Treasury continues to believe that extraordinary measures will be exhausted no later than October 17, 2013. Each of these measures is authorized by law, and each has been used by previous Secretaries of the Treasury during past debt limit impasses: Treasury will suspend, as necessary, the daily reinvestment of the portion of the Exchange Stabilization Fund that is invested in Treasury securities. Treasury will enter into a debt swap with the Federal Financing Bank and the Civil Service Retirement and Disability Fund (CSRDF), which will lead to the elimination of a limited amount of debt that counts against the debt limit...It is important to note that once the final extraordinary measures are exhausted, no later than October 17, we will be left to meet our country's commitments at that time with only approximately $30 billion. This amount would be far short of net expenditures on certain days, which can be as high as $60 billion.  

Will the non-payment of workers keep the debt ceiling at bay for a while?

A good starting point is the graph below from the Bipartisan Policy Center. For an order of magnitude calculation, let's say 2 million federal employees and contractors aren't paid (maybe a bit high) until the debt ceiling issue is resolved. If the average daily cost to the government per employee or contractor is $200 a day (maybe a bit low) then about $2 billion a week is deferred. Then if we assume the federal deficit of about $2 billion a day (The non-partisan Congressional Budget Office estimated the FY2013 deficit would finish up at about $640 billion), it takes a work week of salary deferrals to buy a day delay of the collision with the debt ceiling...which is not a lot. So, starting now,  the Administration has to negotiate both issues because the clock is ticking with or without a "government shutdown".

US Government Closed for Ceiling Repairs

Regarding the government shut-down, the administration and the Republicans are on separate lonely islands, like Gilligan and Crusoe (or Piggy and Jack Shepard). Neither party sees a way to rejoin civilization without egg on its face.

So, the stalemate will continue (and Boehner will live in his red hat) until they start negotiating the debt ceiling. The debt ceiling is the bridge home, egg free.

Spoiler alert! The final chapter of this drama is that the administration will make a small adjustment to the Affordable Care Act that doesn't delay its funding (e.g. a repeal of the medical device tax) in exchange for a comfortable increase in the debt ceiling.

If the markets think otherwise, they're wrong.