TribLIVE

| USWorld


 
Larger text Larger text Smaller text Smaller text | Order Photo Reprints

Economists explain why Fed's taper could spark market meltdown

Daily Photo Galleries

By The Washington Post
Sunday, March 2, 2014, 12:01 a.m.
 

WASHINGTON — Last summer, the markets went wild amid speculation that the Federal Reserve was planning to dial back purchases of Treasury bonds. Bond yields spiked, and stocks fell. But then things calmed down. And when the Fed ultimately did take action, the “taper” went off without a hitch.

Now a major paper by a quartet of top economists suggests that confidence in the Fed's ability to taper without causing market chaos may be misplaced.

The paper, presented on Friday at the Monetary Policy Forum in New York, argues that complex financial instruments, such as the ones during the 2008 crisis, are not what cause a panic. Rather, panics can occur when good ol' money managers get caught up in a herd mentality.

The economists — Michael Feroli, Anil Kashyap, Kermit Schoenholtz and Hyun Song Shin — say that as the Fed continues to taper and prepares to raise interest rates, probably in late 2015, the end of easy money could set off another panic.

“Stimulus is not a free lunch, and it comes with a potential for macroeconomic disruptions when the policy is lifted,” they write.

The paper uses the “taper tantrum” of 2013 as a case study. The Fed had been buying $85 billion in long-term bonds each month to stimulate the economy. But several top Fed officials said in public remarks that the central bank could soon begin to scale back the purchases, triggering fears that years of easy-money policies were coming to an end.

The bond market freaked, sending the yield on the 10-year Treasury spiking to 3 percent. That rippled into the economy as mortgage rates shot up, threatening the recovery in the housing market.

The Fed lurched into damage-control mode, reminding investors that reducing the quantity of monthly bond purchases was not like raising interest rates. The Fed quickly seemed to contain the situation, and ever since, conventional wisdom has been that the Fed and the markets were speaking the same language.

The new paper suggests that this may not be so.

During the “taper tantrum,” then-Fed Chairman Ben Bernanke blamed some of the sell-off on speculative, highly leveraged traders who had to rush to cover positions. And that was a good thing, he said, because it got rid of some of the “froth” in the markets.

But the study showed that much of the volatility came from vanilla fund managers scrambling for the exits. It wasn't just a small group of speculators who were out over their skis; it was the managers of pensions and mutual funds. No one wanted to be the last man standing in a big sell-off.

Feroli and the other economists think of market responses like this as being a potential problem as the Fed continues to taper and then prepares to increase interest rates in a few years.

The longer the Fed waits to exit, the economists say, the more risk there is. For example, the Fed is boosting the economy through guidance that interest rates will stay low for a long time. But officials can't control how the market will react when the central bank relaxes that commitment.

The trade-off is “between more stimulus today at the expense of a more challenging and disruptive policy exit in the future,” the authors conclude.

What is a central bank to do? The paper is short on policy prescriptions.

The authors say the Fed should consider the “taper tantrum” to be a warning that the road to normal policy could be rockier than expected.

 

 
 


Show commenting policy

Most-Read Nation

  1. D.C. charges woman over armed protest
  2. Locavore movement takes to deer hunting across country
  3. Former nuke commander linked to fake poker chips
  4. U.S. to arm Iraq’s Sunni tribesmen
  5. 3-mile buffer suggested for grouse breeding, oil and gas drilling
  6. New nuke carrier will arrive late, incomplete
  7. E-cigarettes cut cravings, study finds
  8. Ferguson, Mo., grand jury to meet Monday, decide on possible indictment of police officer
  9. Bighorn sheep escapes Los Angeles Zoo
  10. Man sets house fire, kills deputy
  11. U.S. releases ‘forever prisoner’ from Gitmo
Subscribe today! Click here for our subscription offers.