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More On Tapering vs Tightening?

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    April 22, 2014

    Tapering or Tightening?

    The agenda for the April 15-16, 2014, research conference hosted by the Federal Reserve Bank of Atlanta has been released (http://www.frbatlanta.org/news/conferences/14fmc_agenda.cfm). Readers who are seriously concerned about monetary policy; the questions surrounding QE; and the issues involving tapering or tightening, liquidity, and regulation may want to spend some time reviewing the presentations and papers. They are thoughtful, and the discussants’ responses are insightful. Two days at the Atlanta Fed retreat sharpened my own thinking about the monetary policy issues we confront today.

    The views that were articulated ranged widely. For example, on one side we heard from the iconic and masterful Allan H. Meltzer. He argued forcefully against the application of quantitative easing and detailed the risks associated with this policy. Meltzer deserves and has earned great respect among students of central banking and monetary policy. His marvelous treatise A History of the Federal Reserve, Volume 1: 1913-1951 sits in my library. It has been a source of historical guidance for me over the years.

    David Zervos, who formerly had his own governmental career and is now with Jefferies, argued in the same discussion panel as an unabashed fan of QE. He was among the discussants who espoused views favorable to the monetary policy evolution that has played out over the last five years. Fed Governor Jeremy Stein added his own views to this panel discussion. Audience participation and questions enlivened the debate in virtually every session of the conference.

    Our view about tapering versus tightening has not changed; however, it was sharpened by two days of discussion and inquiry among this formidable assemblage of policymaking talent, with representatives from organizations worldwide. It was a privilege to be among those who gathered at the Atlanta Fed conference.

    We can consider the issue of tapering versus tightening with a metaphor. Assume a traveler is driving on a highway at 85 miles per hour. The driver decides to slow down and stop to obtain a much-needed rest after a long journey. The driver can slam on the brakes, stop with an abrupt jolt, and disturb or maybe even injure everyone in the car and all those around it. The Fed flirted with that approach last spring and summer and paid a price for the effort. The jolt slowed the economic recovery. It was counterproductive.

    The alternative is to slow gradually. Take the speed from 85 miles per hour to 75; then, continue for a few miles. Then, drop to 65 mph. Continue to reduce speed. Over the course of time, speed will steadily but gently fall to zero. The passengers will not react in fear of a coming jolt. The travelers in other cars will not be surprised or hurt. Speed will decrease in a predictable manner, particularly if everyone is informed of the move ahead of time so they can all adjust.

    That is a description of tapering. The speed changes, but the direction does not. Only when a neutral position of zero has been reached does forward motion cease. Even then, there is no reverse. No going backwards. We will have come from 85 miles per hour to a resting position. We are not backing up.

    Look at the Fed’s history. A resting position for the Fed is still a gradual expansion of its asset holdings sufficient to provide the banking system with necessary reserves and to supply the world with currency in the form of US dollars. The Fed’s balance sheet is nearly always growing. It is growing as long as demand for required reserves and currency in circulation grows. There is half a century of history to support the long-term growth rate. That means the Fed will not actually go to zero when it finally neutralizes trillions of dollars in excess reserves many years from now. It will still maintain a certain growth path.

    Let’s talk about the excess reserves, since they are an issue currently under discussion and were debated at the Atlanta Fed conference.

    The Fed is aware that gradual tapering will lead it to a position next year of needing to deal with excess reserves. It is already introducing policy changes and techniques to alter interest rates and the manner in which excess reserves are handled. It will have various applications on hand when that transitional time is reached next year and the year after. The Fed’s policy makers are now abundantly aware of the fact that they cannot abruptly change or jolt the system. They have “been there and done that” and realize that is a mistake.

    The takeaway and metaphor lead us in a logical fashion to the following conclusion. Tapering is not tightening. There is no relative tapering, meaning relative tightening. That does not work in monetary dynamics. The rate of change of an expansive policy does not negate the fact that the policy is still expansive. When the expansive portion runs out, it will be neutral, not negative. That is very clear to this writer.

    All of this means that the central bank’s policy is predictable and dependable for the next couple of years. It is not the intention of the Fed to surprise markets or market agents. It is their intention to develop, articulate, and explain a consensus view as best they can. Those who hear the descriptions can then figure out what they are going to do and how they are going to do it as the speed eases off from 85 miles per hour to zero miles per hour over the course of a year. It will stay at zero for two or three years or maybe a little less.

    Fed policy is predictable. Interest rates at their present very low levels are predictable. Markets and market agents have to look elsewhere for the elements that will alter the pricing of assets. As long as the Fed maintains this approach of policy predictability and gradualism, market-based asset prices will have an upward bias.

    The economy will have a growth bias, albeit at a slow but improving pace. We continue to be optimistic about the economic recovery and about asset markets. We accordingly maintain our full investment position.David R. Kotok, Chairman and Chief Investment Officer

    About The Author

    Images: Flickr (licence details)

    About the Author

    David R. Kotok cofounded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in economics from The Wharton School of the University of Pennsylvania, an M.S. in organizational dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a masters in philosophy from the University of Pennsylvania.

    Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a participant in Bloomberg radio programs.  He is a frequent contributor to CNBC programs, including Morning Call, Power Lunch, Kudlow & Company, Squawk on the Street, Squawk Box Asia, and Worldwide Exchange. He co-authored the book Invest in Europe Now!

    Mr. Kotok currently serves as a Director and Program Chairman of the Global Interdependence Center (GIC) (www.interdependence.org), whose mission is to encourage the expansion of global dialogue and free trade in order to improve cooperation and understanding among nation states, with the goal of reducing international conflicts and improving worldwide living standards. Mr. Kotok chairs its Central Banking Series, and organized a five-continent dialogue held in Philadelphia, Paris, Zambia (Livingstone), Hanoi, Singapore, Prague, Capetown, Shanghai, Hong Kong, Rome, Milan, Tallinn, and Santiago, Chile. He has received the Global Citizen Award from GIC for his efforts.

    Mr. Kotok is a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), serves on the Research Advisory Board of BCA Research, and is also a member of the Philadelphia Council for Business Economics (PCBE).

    Mr. Kotok has served as a Commissioner of the Delaware River Port Authority (DRPA) and on the Treasury Transition Teams for New Jersey Governors Kean and Whitman. He has also served as a board member of the New Jersey Economic Development Authority and as Chairman of the New Jersey Casino Reinvestment Development Authority.

    Mr. Kotok hosts an annual Maine fishing trip, where, it is rumored, most of the nation’s important financial and economic decisions are actually made.


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