Economic Sense: What Yellen Is Not Telling You About the Taper

February 28, 2014 Updated: April 24, 2016

Sure enough, Janet Yellen talked about economic data in her testimony before the Senate Banking Committee Thursday.

Consumer spending was softer than expected and so were the gains in employment. It might be the weather. In any case the Fed needs to keep its options open, Yellen implied.

What she didn’t tell you is that the taper was never about the vague economic targets the Fed arbitrarily set and then changed. In fact, other circumstances might allow it to increase asset purchases again.

Taper Not About Data

We need to come clean with the fact that the taper—the gradual reduction of the Fed’s monthly purchase of assets—was never about economic data. The Fed first named specific levels of unemployment and inflation, and then changed either the numbers or the definitions as soon as the data came close to reaching its targets.

In spite of the improving data, the Fed would have liked to keep printing money and buying bonds, but had to stop for other reasons. Everything has to do with the assets the Fed was buying.

Ever since the Fed unleashed quantitative easing (QE) in September 2012, it has been buying $40 billion in mortgage-backed securities (MBS) and $45 billion in Treasurys every month.

What was the real reason why it needed to reduce purchases in December 2013? These markets were running out of paper to supply the Fed’s buying frenzy.

In November, the Fed was estimated to buy $3 of MBS for every $1 that was newly created. Since QE started in 2009, it racked up more than $1.5 trillion worth of MBS, leading some brokers to complain that liquidity is worse now than it was during Bear Stearn’s collapse in 2008.

However, for MBS, this wasn’t such a big issue, despite the market being smaller. Banks were happy to unload questionable and illiquid securities anyway and MBS don’t serve an important function in the financial markets.

But Treasurys do. The U.S. Treasury market is the deepest and most liquid capital market in the world. Not only that, but banks and other financial institutions use Treasurys as the foundation for all sorts of margin and derivative transactions.

If the Fed buys up all the bonds, then there is nothing left for the private sector to keep on transacting. That would be bad news for anything from corporate debt to the stock market.

But hold on, doesn’t the current stock of debt stand at $17.3 trillion? Isn’t there plenty to go around, even if the Fed holds $2.3 trillion? The answer is no.

First, only $11.8 trillion is marketable—the rest is held in nonmarketable intra-government bonds. Second, only $1.4 trillion is actually in bonds that run longer than five years, or higher quality collateral.

Converted into 10-year bonds for simplicity, the Fed owned about 30 percent of these 10-year equivalents in December and was consuming about 0.25 percent of this market per week. That’s up from just 13 percent in 2009 and too much for the private sector to take. Hence the taper.

New Debt Means New Printing

Normally, the Fed and the private market could count on the federal government to just issue new debt and supply new bonds for the Fed to monetize. Not in 2013, however, when the sequester, the government shutdown, and numerous debt-ceiling debates hampered new issuance.

With the passage of the clean debt limit, this obstacle has been effectively removed. The Treasury can issue as much debt as it wants until March 2015, as the debt ceiling is simply suspended until then. Several very successful debt auctions in the beginning of 2014 prove both the appetite for bonds and the willingness of the government to supply them.

The Congressional Budget Office thinks that Federal deficits will be $1 trillion every year for the next decade—enough for the Fed and the private market.