2013-08-19

Why Is The Fed Tapering? Did They Realize QE3 Is A Failure?

Has anyone made the connection between QE and the federal deficit?

Note that fiscal years end in October, so the year's don't line up perfectly. First the federal deficit:

FY2009 $1413 Billion Deficit

FY2010 $1294 Billion Deficit

FY2011 $1299 Billion Deficit

FY2012 $1100 Billion Deficit

FY2013 $759 Billion Deficit
The last number is estimated.

Now let's look at QE. I'm using the government's fiscal year during which the bulk of the Fed program was in effect.
FY2009 $1.55 trillion in MBS and Treasures (QE1)

FY2011 $600 billion in Treasuries (QE2)

FY2012 $400 billion in Treasuries (Operation Twist)

FY2013 $1.02 trillion in Treasuries and MBS (QE3)
FY2010 only saw a partial QE program. It ended in March and Bernanke didn't pre-announce QE2 until August. The markets went 4-5 months without QE. All hell broke loose in Greece and there was a flash crash in May 2010.

Here is part of the Fed's QE3 announcement:
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

How did interest rates perform, with $1.02 trillion in Fed buying and a much smaller U.S. Treasury bond creation (courtesy of the smaller deficit)?

From last September: Why QE3 will completely fail. Click the link to read the whole thing, below is the conclusion:
The U.S. is in a debt crisis. This crisis exploded in 2008 and was relatively quickly halted by federal government and Federal Reserve emergency policies. In the ensuing years, the U.S federal government ran large fiscal deficits and the Federal Reserve engaged in various policies designed to stimulate the economy. The result has been stasis at a lower level of economic activity, with consistently high unemployment.

The impact of QE3 will be a short-term bounce in financial markets and commodities, a portion of which was anticipated by investors ahead of the QE3 announcement. When QE3 fails, the Federal Reserve will announce an increase in the amount of debt purchases or the economy will sink into recession, with very negative results for the financial and commodity markets. That said, while deflation is the overriding concern today, investors should be hedged with precious metals.
I missed the rise in rates because I expected general economic deflation to keep rates low. And even with a shrinking deficit (and Treasury issuance), QE3 was too small to generate inflation or suppress interest rates. What's shocking is that the failure of QE has the Fed talking about a taper. But now we will really see if my forecast was correct. If the Fed does begin to taper in September, we should see market effects by November at the latest if deflation takes over once more.

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