Tag Archives: Bond buying

The Truth Behind Fed Tapering

September 6, 2013

There has been a lot of talk recently in the media on how the Fed will likely taper back on their asset purchasing program known as QE (quantitative easing) in September. The economic media “experts” have almost all gotten behind the same group think strategy and have decided that, based on Bernanke’s August speech, the taper is right around the corner due to an improved U.S. economy.

However, if you take a step back from all of the media talking heads and nonsense, it is easy to see that it is extremely unlikely the Fed will taper back on their asset purchases. Here is the economics translation to the truth behind the tapering, or lack of it:

First, ask yourself this question: What is the purpose of quantitative easing? The shortest of short answers is to keep down interest rates. Free market interest rates are determined by the bond market. If the U.S. government wishes to borrow $100,000 they will attempt to sell ten $10,000 U.S. government bonds. Bonds are simply an IOU that the government gives to the lender, and in return they have to pay the lender interest on the amount they borrow. So the U.S. government announces they will sell ten $10,000 bonds to the public at an interest rate of 2%. If everyone wants one of these bonds and thus the demand is strong, the U.S. government can lower the interest rate and pay less for borrowing the money. In contrast, if no one is willing to buy the bonds at 2% the government would be forced to raise the cost of borrowing (interest rate) until buyers were interested.

Quantitative Easing increases the demand for U.S. bonds, thus keeping interest rates low. If the Fed was not buying 85 billion dollars worth of bonds and mortgage securities a month, then demand would not meet supply at current interest rates and interest rates would need to rise in order for the U.S Treasury to sell enough bonds. Unfortunately the U.S. Treasury needs to sell these bonds in order to run the government by financing the deficit, as well as making interest payments on our current national debt of about $17 trillion.

Here is what I believe is the missing bit of information in the heads of all the people talking about the taper to come in the near future: the government needs to pay interest on our current debt of $17 trillion. The United States borrows money to pay interest on our current debt as the current debt continues to rise. Furthermore, much of the current debt has short term maturity dates due to Bernanke’s genius ploy of ‘Operation Twist’ in which he refinanced the country’s long term debt into short term debt due to historically low interest rates.

In 2011, the government collected about 2.5 trillion in taxes and spent about 3.5 trillion for a deficit around 1 trillion. So what is going to happen if interest rates rise to a number slightly higher than the current historic lows, lets say 5%? At a 5% interest rate, the government would need to pay $850 Billion in interest on the $17 Trillion debt. If by some miracle congress was able to balance the budget so that annual deficits were $0, we would still find ourselves going deeper and deeper into debt each year just by the interest payments. At this point it becomes crystal clear to our biggest buyers of U.S. bonds, such as China and Japan, that the U.S. can never pay back their debts without running the printing press and thus greatly inflating the value of the dollar away. With this realization they will decide to no longer lend money to the United States leaving the country with the single option of money printing to pay off debts and finance the deficit resulting in hyperinflation.

All of this rests on interest rates, which Quantitative Easing has been designed to keep low. I don’t believe the economy is recovering the way the media reports, however it is a different debate and irrelevant to the Fed’s decision to taper. In the end tapering will simply decrease demand for bonds and cause interest rates to rise. While the Fed demand for bonds is artificial and will eventually come back to hurt the country, in the short run Bernanke cannot afford to taper and risk interest rates rising.

Final thought: Despite all of the talks in the media of tapering, I believe we will see an increase in QE before we see a decrease.