A heretical take on the taper tantrum

There is a lot of discussion these days (e.g. see here) about the prospects for — and implications of — the ECB “tapering” its asset purchases

I do not have much to add to that discussion, beyond emphasizing that euro-QE is quite distinct from the Fed’s QE, because it involves an implicit credit risk transfer from investors in the periphery to tax payers in the core of Europe, which are stronger hands.  So the considerations guiding — and implications of — a euro-taper are likely to be quite different from the US experience.

But this discussion prompts me to set out a bit more fully my heretical take on the US “taper tantrum”, which ran from late-April to mid-September of 2013.  The consensus take on this issue incorporates a false premise that seems to misinform much discussion of the American experience with QE, although with the passage of time – and learning – Americans at least are beginning to recover the plot.

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The false premise is that all aspects of US monetary policy during the early post-crisis period can be distilled down to “QE.”  Many people have a disconcerting tendency to say “QE” when they really mean mean ZIRP, dovish interest rate guidance or even the real-economy forces that have encouraged bond yields to be lower after the Global Financial Crisis than before it.

If one calls every possible influence on bond yields “QE” then of course one is going to find that QE innovations have been potent forces. If they are everything, then yes they will explain everything.

I am not going to re-litigate the case against the presumed high efficacy of QE in this post. I have already been plenty tedious on that point, and I am confident that time will do the work from here on in.

For example, the misguided flirtation with H money from about 18 months ago to a couple months ago was itself premised on a recognition that QE is not a particularly effective tool, at least looking forward.

In fairness, that is not necessarily evidence that QE was not potent when actually applied in the US, but I have had my say and will let time work on that one too.

Here I would like to just point out a few facts about the monetary policy discussion in the spring and summer of 2013 that tend to get glossed over among those who instinctively define QE as everything and find that it was responsible for everything.

First and most importantly, there is no reason to believe that market estimates of the forward path of the Fed’s balance sheet (measured in, say, 10-year equivalents relative to GDP) even fell during the taper tantrum period.

Certainly, the Fed was discussing tapering and that theme was heavily and newly prominent in the minutes of the April/May FOMC meeting.  But at the same time, Fed officials were becoming increasingly clear, in other less formal communications, that they had no intention of moving quickly from a taper to asset sales.

Indeed, I recall an academic paper showing that the implied forward path of the Fed’s balance sheet was being tilted slightly higher over the tantrum period, because news regarding the timing of assets sales (being pushed back) was dominating news regarding when the initial taper would arrive.

Unfortunately, I do not recall that paper well enough to be able to retrieve it from the internet!  If you know of that paper, please send me a note. Apparently, I am the only one that has Googled it, which means the search gets no hit. I blame my inability to retrieve it purely on my being so uniquely insightful, then. 😉

Anyhow, QE was supposed to reduce the term premium by reducing the forward stock of default-free rates duration to be taken down by the market. Given that the taper tantrum did not involve that stock rising, there is no reason to believe that the officially-asserted mechanism for QE was even changing much during the tantrum period.

Second, there was a clear sense during the early stages of the taper tantrum that the bond market was overheating and that the Fed was considering changing “monetary policy” to reverse that overheating.  Here is the money paragraph, with emphasis added, on that theme from the minutes of the April/May FOMC meeting:

At this meeting, a few participants expressed concern that conditions in certain U.S. financial markets were becoming too buoyant, pointing to the elevated issuance of bonds by lower-credit-quality firms or of bonds with fewer restrictions on collateral and payment terms (so-called covenant-lite bonds). One participant cautioned that the emergence of financial imbalances could prove difficult for regulators to identify and address, and that it would be appropriate to adjust monetary policy to help guard against risks to financial stability.

During this period, the Feds’ resident worry wart over financial stability was Jeremy Stein, who eventually emerged as a hero of the Failure Caucus opposing the Fed’s efforts to achieve a return to full employment.  The mythical Jeremy Stein is thought to have agitated against a continuation of QE on the grounds that too much of it led to financial overheating. LOL

In fact, that is exactly the opposite of what Jeremy Stein was asserting – at least in public – at the time. Stein’s view was that financial overheating could (in principle) be reduced by stepping up the pace of QE even while possibly raising the level of the fed funds rate.

Such a combination would presumably reduce the slope of the yield curve and thus the incentive for “maturity transformation” in the banking system, which Stein viewed as particularly dangerous. At the same time, the combination could (in principle) be neutral as regards the total volume of stimulus delivered to the economy itself.

But this simple fact does not fit the dumbed down script of the taper tantrum, so it attracts studied indifference.  Perhaps that puts it a bit too strongly. Another interpretation is that Jeremy Stein was not that important (ultimately true, mercifully) or that the sequencing from a QE taper to rate hikes was known, which I will get to in a moment.

Janet Yellen was then Vice Chair and was obviously quite a bit more important than Stein. Her take on this issue was in line with Stein’s, although she was not a professional worry wart about financial overheating.

She mentioned at the time that IF one were worried about financial overheating, then the obvious remedy WOULD be to raise the funds rate or at least drop the rates guidance, as confidence in a prolonged period of low rates was a much more obvious source of potential financial instability than mere QE.

My point here is that the Fed was clear (even if wrongly so) that they were concerned about financial overheating at the time and meant to do SOMETHING about it.  People knew that the sequencing would involve first a taper, then a conclusion of purchases, and then loss of the rates guidance, followed ultimately by rate hikes. So, yes, the taper was the most proximate consideration. But it was not for that reason necessarily the most important consideration.

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Disentangling a taper from a shift in rates policy was impossible. And the market responded accordingly. During the entire taper tantrum, there was no flattening of the yield curve between and 5- and 30-year maturities.  If the mechanism were duration removal or a presumed slowdown of it, then the coupon curve would presumably have flattened steepened.

It is very simple to say that the bond market weakened in the middle two quarters of 2013 because the Fed was threatening to taper.  In fact, the bond market weakened because the Fed was threatening to TIGHTEN broadly speaking and because economic developments were unfolding in a manner consistent with that.

Ultimately, the Fed tapered and a reinforced its rates guidance, implicitly giving the long digit to Stein and his ilk.  Because of the latter, the taper did not matter much.  After all, it is rates policy, rather than duration removal, that is the most important way in which the Fed influences the term structure. But that is a separate discussion.

One final aside. In re-reviewing this history, I noticed the Fed repeatedly referred to policy as “extremely accommodative” during the middle of 2013.  LOL

That too got airbrushed away, along with the extreme overconfidence in the efficacy of QE.  Leaving aside that “accommodative” quite intentionally does not actually mean anything.