Bernanke won't taper, unless bond market or dollar collapses

In what had to be one of the most eagerly-awaited announcements of the year, US Fed Chairman Ben Bernanke announced his decision not to taper his bond purchases for now. In my thoughts on this topic written a couple of months ago, QE or no QE , I had said that Bernanke cannot taper “meaningfully” - not only at the September meeting, but ever. No drug addict can give up drugs without first experiencing withdrawal symptoms - which can be painful. It is easier to continue imbibing drugs even if they ultimately kill you.

Bernanke won’t do a meaningful taper unless he does a U-turn in terms of his economic beliefs and accepts a collapse of the bond market and a deep recession as a solution to the US’s problems of excessive debt and excessive consumption - which seems unlikely. The other situation in which he may taper is if there is a full-blown US dollar currency crisis.

I am not saying that the chances of a mild taper to the tune of $5-10billion a month is very low. In fact, I thought that Bernanke would taper a bit and the revolt in the bond market, with its cascading effects on the housing market as well as government finances, would have made him reverse course. With the Fed being almost the only buyer in the treasury market, any taper would have caused the rates to rise substantially. Even talk of a taper has caused rates to almost double from slightly over 1.5 percent a few months back to nearly 3 percent today. (It was 2.69 percent for 10-year bonds yesterday after the Fed announcement).

The media would have portrayed the taper, if it had happened, as a tightening exercise. That’s how low the expectations of the media have been set by central banks - not only by the US Fed, but also by its counterparts in other parts of the world. Most central banks, including our own RBI, are running massively accommodative policies whose deleterious effects have only just started playing out. And yet, all that we can hear in terms of expectations from the government, industry bodies and the media channels are requests for further easing.

So what should Bernanke have done? Bernanke should never have lowered the rates to zero in the first place and indulged in this exercise of bond buying. It was the monetary easing by the previous Fed Chairman, Alan Greenspan, that led to the housing bubble with all the accompanying imbalances in the US economy. This round of easing has been greater, by a wide margin at that, and so the consequences are going to be that much worse than in 2008 when the current bubble in treasuries/ bonds, fiat currencies and “confidence in governments” bursts.

Given where we are at, the best course for Bernanke would be to wind down the bond buying programme, do a Paul Volcker on rates, and raise them substantially to generate savings. At the same time, he should force the government to cut back on its expenses. Given the near $20 trillion acknowledged national debt, even a 5 percent rate would put the interest outgo at $1 trillion, forcing the US government to massively scale down its unfettered spending programme. Ofcourse, there is zero chance that Bernanke will do that and so we will continue to witness the train wreck in motion, as has been the case for the last several years.

The action in the treasury market is likely to be interesting in the months ahead. While most participants would expect the yields to fall over the short to medium term, I think the opposite is likely to happen. The initial reaction that we have witnessed in bonds all over the world is merely a “head fake”. After all, continued quantitative easing (QE) should logically imply a lower purchasing power for each existing unit of the currency and it’s quite natural for the markets to expect a higher return for holding onto something that is likely to lose its value over a period of time.

So this is what is likely to happen: yields, after softening for the next few days, are likely to begin to rise and Bernanke or his successor would be forced to increase the bond buying programme to $100 billion a month from the current $85 billion to buy more treasuries to decrease the yields. As I wrote in the previous article, $100 billion a month will happen before $50 billion a month - and with this continued stimulus distorting the markets to a greater degree, a sustained improvement in the economy or the labour markets is never going to happen.

As Ludwig von Mises of the Austrian School would love to compare, any economy on a central bank-induced cheap credit binge is like a drug addict… with time, one needs greater and greater dosages to even maintain the status quo. Any cleansing process of this addiction has to start with the rather painful, but much needed, withdrawal symptoms. In the case of the US economy, these symptoms would include substantially higher bond yields, resulting in a very deep recession, a massive reduction of government expenditure, a cleansing of malinvestment in the bubble sectors and reallocation of freed up resources on a market-driven basis.

The path that Bernanke has put the US on is very different. He has taken the route of greater doses of stimuli that would allow him to temporarily postpone the withdrawal symptoms, but would ultimately cause the death of the patient. That has been the case for the last several years, but this time it indeed is going to be different. The patient under question is not only the US economy, but the US dollar as well.

Shanmuganathan “Shan” Nagasundaramis the founding director of Benchmark Advisory Services - an economic consulting firm. He is also the India Economist for the World Money Analyst, a monthly publication of International Man. He can be contacted at shanmuganathan.sundaram@gmail.com