How will tapering affect the markets?
Some are convinced that the Fed’s great escape can only be bad news for both stocks and bonds. Others believe that it is time to reduce the pace of QE3, citing a combination of diminishing returns relative to its benefits, increases in its marginal costs, and/or a U.S. economy that continues to expand modestly and, thus, is less in need of emergency support. I will admit to being in this camp: In my opinion, tapering is good news for long-term investors.
I am cheering for the U.S. economy, as I did for Andy Dufresne in The Shawshank Redemption, to finally chip through to a better reality. We’re not there yet (trend real GDP growth remains stuck near 2%), but we’re closer than we’ve been since the financial crisis.
Nevertheless, it will likely be quite some time (at least 2015) before short-term interest rates begin to rise above 0% and normalize given still-tepid wage inflation and still-elevated unemployment. And in the interim, savers may continue to suffer, and long-term U.S. interest rates may struggle to rise much further from present levels given a Fed still on hold. But for the first time in years, we are at least contemplating life on the other side of the tunnel.
Just like Andy Dufresne, I have eyes wide open to what may be a long and difficult journey—marked by occasional market setbacks—toward an environment of less monetary policy stimulus. The unprecedented measures undertaken by the Fed and other central banks in response to the financial crisis have left us in uncharted territory. The tools at the banks’ disposal, like Dufresne’s rock hammer, are unproven, since no economy has yet to fully test the unwinding capabilities now under contemplation. Our path is likely to be rocky at times. Just as Dufresne’s heroic getaway was aided by the noise of a fortuitous rainstorm, we too may find that our escape will depend on the evolving economic conditions we encounter.
Still, I like America’s chances.
Do you?
Joe Davis, Ph.D., is Vanguard’s chief economist and head of Vanguard Investment Strategy Group.
The author would like to thank Andrew Patterson in our Investment Strategy Group for making substantial contributions to this blog post.
*Reserves are a liability to the Fed, but an asset to banks. They can be thought of as an electronic IOU from the Fed to the banks.