Last summer, when speculation heated up over the Federal Reserve’s plans to begin to “taper” its bond purchases, markets went wild. Bond yields spiked and stocks fell. But things calmed down, and when the Fed ultimately did taper, it went off without a hitch.
But a major new paper by a quartet of top economists now suggests we shouldn't be so confident the Fed’s exit from its extraordinary efforts to stimulate the economy will continue to hum along without causing market chaos.
The paper by Michael Feroli, Anil Kashyap, Kermit Schoenholtz and Hyun Song Shin presented at the Monetary Policy Forum in New York on Friday argued that you don’t need complex financial instruments -- like we had in the 2008 crisis -- to cause a panic. Rather, panics can occur when good ol' money managers get caught in a herd mentality.
The economists argue say that as the Fed continues to taper this year and prepares to hike rates, likely 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 summer 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 suggested in public remarks that the Fed 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 real 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 at all like raising interest rates. The Fed seemed to contain the situation -- and ever since, conventional wisdom has been that the Fed and the markets are speaking the same language.
But the new paper suggests that may be this is not so.
Back during the "taper tantrum," then-Fed Chairman Ben S. Bernanke blamed some of the sell-off on speculative, highly-leveraged traders who had to rush to cover positions. And that was actually a good thing, he said, because it got rid of some of the "froth" in the markets.
But the study showed that, in reality, much of the volatility actually 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 see market responses like this as potentially a major problem as the Fed continues to taper, and then ultimately 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, right now the Fed is boosting the economy through guidance that interest rates will stay low a long time, but officials can’t fully control how the market will perceive it when the Fed 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 -- though Fed Gov. Jeremy Stein, the central bank’s most vocal advocate for using interest rates to pop asset bubbles, could offer some insights during his critique of the paper at the conference this morning.
The authors suggest the central bank consider the taper tantrum a warning that the road to normal policy could be rockier than they think.