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Michael Gayed: What Makes Tapering Different From Tightening


Here's how speed and inflation expectations play a role.

There is nothing either good or bad but thinking makes it so.
-- William Shakespeare

For the past several months, the Federal Reserve has been going out of its way to differentiate tapering from tightening. The thought process here is that even if the Fed pulls back on the pace of its current quantitative easing program, rates will remain exceptionally low on the short end until unemployment and inflation targets are met. A reduction of stimulus is not the same as a hawkish policy, or so the discussion goes. Yet, the construct and debate over tapering and whether that equates to tightening needs to be reconsidered.

First, tapering absolutely can be perceived as tightening depending on how the market reacts. If yields were to spike again as they did in May-July, that is a hawkish reaction by the bond market and can be quite damaging to the economy (especially housing). As a matter of fact, the Fed purposely did not taper in September because of "tighter financial conditions," which was code for the yield spike that took place. If tapering causes a significant move in yields, it's a rate hike, pure and simple, and serves as a deflationary shock.

When is tapering not tightening? When inflation expectations trend higher and yields do not spike. Believe it or not, we may be getting nearer to that type of a scenario. While inflation expectations have been notably disconnected from US equities all year, there are some signs at the margin of an improvement. Take a look below at the price ratio of the iShares TIPS Bonds Fund ETF (NYSEARCA:TIP) relative to the nominal iShares 7-10 Year Bond Fund ETF (NYSEARCA:IEF). As a reminder, a rising price ratio means the numerator/TIP is outperforming (up more/down less) the denominator/IEF.

This is one way (among others) of tracking inflation expectations. Note the far right of the chart, where some minor picking up of inflation expectations seems to be taking place. This, combined with what appears to be improvement in commodities at the margin, might mean the market has not only discounted tapering, but is now beneath the surface and starting to expect that inflation may begin to rise near term despite headline data, which indicates quite the opposite. Clearly the trend is very early and must hold, but this remains the key to determine whether tapering is tightening.

Anyone care to guess how many times I used the word taper for this article? I'm going to bet "too many…"
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