How Continued Tapering Will Affect Interest Rates and Inflation

How Continued Tapering Will Affect Interest Rates and Inflation

The Federal Open Market Committee (FOMC) announced last week that it would once again cut its quantitative easing (QE) program by $10 billion. This marks the fourth consecutive quarter that the Fed has tapered although the Fed Funds rate will still have a target of zero for the foreseeable future.

There is now $45 billion being pumped into the U.S. economy – $25 billion in treasury purchases and $20 billion in mortgage-backed security purchases. The reduction came on the heels of relatively weak first quarter GDP data where the economy grew at a much less-than-expected 0.1% rather than the 1% that was widely anticipated. For the fourth quarter, GDP grew at 2.6%. The Fed claimed that adverse weather conditions were responsible for the sub-par performance in the first quarter and maintains that second quarter GDP could be as high as 4%.

The economic impact of reduced QE

When the last round of QE began, many economists claimed that the infusion of so much liquidity into the money supply would cause interest rates to spike and dilute the value of the dollar causing runaway inflation. So far however, it seems that Fed activity has had little impact on inflationary figures and interest rates.

In the last two years, the interest rate on the 10-year T-Note has mildly risen from 1.87% to around 2.6%, although it did briefly touch 3% at the beginning of 2014. Even still, it’s hardly the sharp climb investors feared might happen.

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Inflation figures are actually the opposite of what many predicted would happen. In 2012, inflation stood at around 1.7% and has dropped slightly to 1.5% for the last two years running. The Fed’s target rate of 2% hasn’t been breached in nearly three years.

Like the surface of a lake with strong currents unseen underneath, the state of the U.S. economy may not be so placid. There are a number of factors at play that could keep inflation and interest rates stable but they’re all working against the clock and time is running out.

The money supply

The quantity theory of money is a widely accepted economic idea where the supply of money in an economy determines price levels, albeit this theory may be more applicable in the long run than in the short run.  Any changes to the money supply will result in proportional changes to price levels. Simply put, changes in the amount of money circulating will cause inflation/deflation.

Here is the basic equation for determining this relationship:

M * V = P * Y

     M = the money supply – amount of money being circulated

     V = the velocity of money – the frequency at which currency is used to purchase domestic goods and services within a given time period

     P = Price levels

     Y = Real GDP

Now that we have the formula, let’s plug in some numbers and see where it leads us. We’ll assume a very basic economy where 1,000 units of goods are sold for $50 each. That represents the right side of our equation. Let’s further imagine that this little economy’s money supply is $10,000. In order for the equation to balance out, that means that money exchanges hands 5 times. $10,000 * 5 = $50 * 1,000.

In order to better understand how this relationship works in the real world, we can use a different form of this equation using growth rates.

      % change in (MV) = % change in (PY)

Looking at it this way, we can see that if one variable were to change, say the money supply (M), then either prices (P) or real GDP (Y) would have to rise as well. The velocity of money (V) is historically a constant figure so it’s safe to say that any changes to the left side of the equation happen with the supply of money (M).

According to figures from the Federal Reserve, the monetary base, or the total amount of monetary assets available in the economy, has expanded by more than 300% since 2008. According to our equation, that should mean that either prices (inflation) should’ve risen or GDP should’ve risen in kind. However, as we saw from the latest GDP numbers and inflation figures, neither has happened. So what’s actually going on?

Lag and other real world problems

In order to fully understand why the Fed could dump trillions into the economy and yet not see any inflation or gain in real GDP, we first must make the distinction between the monetary base and the money supply as measured by M2. M2 takes into account bank deposits including cash, checking, savings, money markets, and other short-term time deposits. What it does not take into account is banking reserves – the deposits held in the central bank and not lent out to clients.

If we look at the expansion of the money supply from 2008 to current, we can see it grow from $7,500 billion to around $11,200 billion – an increase of only 50%. Further investigation reveals that more than 80% of money created by QE stayed behind as bank reserves instead on being introduced into the economy through lending and other banking activities.

If the money doesn’t ever get circulated, it won’t impact price levels or GDP. It does present another problem though; what happens when QE is completed and the economy reasserts itself enough that banks begin lending again?

Historical accounts show that after an expansion in the money supply, inflation begins to rear its head around 18 – 24 months later. If the Fed continues its tapering program as expected, we could start to see inflation sometime around the middle of 2016.

Interest rates could begin to move much sooner. The FOMC has already raised predictions for short-term interest rates from 0.75% to 1.0% by the end of 2015 and 1.75% to 2.25% by the end of 2016. Rates across the board should start floating upwards with a possible sharp tick up in early 2015.

The unknown factor

The global economy means that countries are interdependent upon each other for predicting their own future. Actions by the central banks of major economies like Europe and Japan will undoubtedly have an impact on Fed activities in the U.S. and could serve to speed up the rate at which inflation and rates are expected to rise.

Japan’s current monetary policy of “Abenomics” is pumping money into its economy at more than twice the rate that the Federal Reserve was during the height of QE. As Japan’s money supply expands, the Yen should continue to weaken against the dollar.

Europe’s central bank (ECB) is considering a stimulus package of its own as growth stagnates in the Euro-zone. As with Japan, the injection of money could negatively affect the value of the Euro.

The US dollar, the preeminent global reserve currency, could rise in the coming year as money flows pour out of both Europe and Japan. The sudden influx of foreign capital could spark a chain reaction that would cause interest rates to rise much faster than expected and lead to a subsequent increase in inflation.

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Currency markets operate a lot like concepts in Physics. Everything is relative. The global economy is still extremely fragile so any surprise growth in the US economy could send investors flocking to American bonds, equities, and treasuries. If the US dollar does begin to climb due to global macroeconomic factors, the Fed may have to implement rate hikes earlier than anticipated to combat rising inflation. The next six months will be key in determining if those fears are worth taking action against.

The mild rise could be falsely attributed to natural causes instead of money inflows creating a problematic scenario for the Fed when the expected rise from the taper finally arrives. Like a rogue wave hitting a ship out in the open sea, the effect it would have on the U.S. economy could bring the bull market to a quick and sudden end. In the meantime, the relative safety of the dollar should continue to attract foreign capital and cause both inflation and interest rates to slowly creep up.

Fariba Ronnasi
CEO, Elite Wealth Management

Full Disclosures:
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions on the companies mentioned through stocks, options or other securities.

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