Taper Vs. No Taper - Let's Meet Somewhere In The Middle

To Taper or Not To Taper…

Volatility in the US equity and bond markets has risen since Ben Bernanke and the rest of the Federal Reserve Board mentioned thepossibility of taperingits bond purchase program - in other words, a potential end to the "free ride" the Fed has been giving investors.

However, economic data is still weak and a reduction in economic stimulus by the Fed may harm the US economy.

The Fed Mandate

In 1977, Congress amended The Federal Reserve Act, stating the monetary policy objectives of the Federal Reserve as:

"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."

Fed projections (provided by the Federal Reserve Bank of Chicago) show future target rates for inflation and employment rising, and gives the Fed a compelling reason to slow down its stimulus program by tapering the purchase of US bonds in order to keep long-term interest rates low.

However, current economic data shows that the projections may be a bit optimistic

Weak Economic Data Continues

Last week's unemployment number declined to 7.3%, continuing a downward trend in

unemployment since 2011:

The problem the Fed is facing, however, is the actual unemployment rate may be

much higher than what the “official” rate shows.

Variable Purchases/Tapering May Be What's Coming Next

Job creation, year to date, remains lower than in 2012. In 2012, a monthly average of

182,000 new jobs were created. In 2013, the average has dropped slightly to 180,000

jobs per month.

In fact, the actual cause of the drop in unemployment may not be that more people

are finding work, but that more people are giving up.

The participation rate in the labor force continues to drop (those who are not actively

looking for work are not labeled as unemployed):

Popping The Bubbles Before They Get Too Big

The question facing investors is if the employment picture is not really improving, then

why would the Fed slow down its stimulus program?

The Fed may be worried about future inflation spikes caused by bubbles forming in

the economy due to a perception of risk-free money – for example in the US stock

market.

Investors continue to drive the stock market to record highs despite any real growth in

corporate earnings. The idea that the Fed will continue to put an ever rising floor on

equity prices has created a perceived environment of practically risk-less investing.

This environment has allowed stock market multiples to expand dramatically without

any real earnings growth.

Variable Taper/Purchase

Going forward we may see the Fed try to keep investors more on their toes by

introducing a more “variable” taper/purchase program.

The average annual amount purchased by the Fed may remain the same (only time

will tell), but we may see Bernanke and company start to adjust purchase amounts

more frequently – thus giving the illusion of tapering without damaging the fragile US

economy.

By adding this element of the unknown, the Fed may be hoping to remove the

perception of risk-less investing in equities and any other bubbles that may be forming

in the US economy.

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