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Affluent Investor | July 22, 2017

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Tapering is Tightening

Photo: Getty Images

Photo: Getty Images

The Fed is having a tantrum over trying to explain to the misguided market (as he views it) that winding down QE is not at all tightening monetary policy. As far as Mr. Bernanke is concerned, the Fed isn’t tightening if the Fed Funds target rate isn’t being increased. While I agree, unfortunately, with the Chairman that raising the Fed Funds target rate from its current zero percent range probably won’t occur until there are two consecutive blue moons, I do not agree with him that lowering the level of monthly asset purchases shouldn’t have any effect on long-term interest rates.

Our central bank believes the current size of its $3.5 trillion balance sheet has the primary influence on money supply growth and level of asset prices (stock analysis). However, I believe the monthly amount of Treasury debt and Mortgage Backed Securities that the Fed purchases holds more sway in the decision by banks to accumulate more bonds (flow analysis).

The goal of the Fed’s QE programs is to cause banks to increase loan volumes in order to boost real estate and equity prices; and to lower the level of long-term interest rates. But banks currently don’t need the nearly $2 trillion of excess reserves in order to increase the money supply through the fractional reserve system. Through a process called ‘sweeping’, new demand deposits are ‘swept’ into time deposits that require no reserve withholding. The two most important factors that determine the level of bank lending and asset purchases are its capital ratios, along with consumer demand for money.

The Fed buys assets from banks, and banks then replace some of those interest bearing holdings with newly issued debt. The smaller amount of Treasuries the Fed removes from bank balance sheets, the less incentive financial institutions have to replace those holdings with more government debt. Therefore, the stock of excess reserves is far less influential on bond yields than the amount of Treasuries and MBS that are continuously being purchased from banks through the Fed’s QE programs.

The bottom line is less Fed buying of Treasury debt equates to more supply that has to be soaked up by the private sector. More supply and less demand leads to falling prices and rising yields. Perhaps this is why every time Mr. Bernanke threatens to attenuate the monthly allotment of Treasury purchases the “misguided market” interprets that tapering as tightening. Because, after all, that is exactly what it is.

More importantly, we need to realize as a nation that the Fed cannot continue expanding its balance sheet by $85 billion each month indefinitely. The economy has been provided with four years’ worth of QE; any benefits derived from such efforts should’ve been fully realized by now.

The Fed has recently hinted that it might start tapering QE by the fall. I hope Mr. Bernanke has the courage to remove the artificial stimulus of bond purchases and allows the economy to operate under the principles of a free market. And, if interest rates rise or the economy falls apart because a $3.5 trillion balance sheet isn’t enough to compel banks to buy more Treasuries, then so be it! At least we will know the Fed has taken a small step in mollifying the devastating effects from the inevitable normalization of interest rates.

Michael Pento is the President and Founder of Pento Portfolio Strategies (PPS). PPS is a Registered Investment Advisory Firm that provides money management services and research for individual and institutional clients.

Michael is a well-established specialist in markets and economics and a regular guest on CNBC, CNN, Bloomberg, FOX Business News and other international media outlets. His market analysis can also be read in most major financial publications, including the Wall Street Journal. He also acts as a Financial Columnist for Forbes, Contributor to thestreet.com and is a blogger at the Huffington Post.

Prior to starting PPS, Michael served as a senior economist and vice president of the managed products division of Euro Pacific Capital. There, he also led an external sales division that marketed their managed products to outside broker-dealers and registered investment advisors.

Additionally, Michael has worked at an investment advisory firm where he helped create ETFs and UITs that were sold throughout Wall Street. Earlier in his career he spent two years on the floor of the New York Stock Exchange. He has carried series 7, 63, 65, 55 and Life and Health Insurance Licenses. Michael Pento graduated from Rowan University in 1991.

 

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