This weeks Barron's says stock market expected to gain 7% by first half 2014. It's time to Taper Barron's says. Most high Dividend securities have and are adhering down. I say bring in on in a measured open transparent manner. It want get over with until the process actually starts.
What recently happened was that the markets reacted so violently to taper talk, that taper was no longer appropriate. So if the economy shows strength, and taper talk returns, will the same happen again? Since this was an unexpected result of taper talk, does the Fed have even a rudimentary understanding of the markets?
In the normal course of business, excess reserves can be removed by the bank, loaned out, and by the multiplication process, the same amount returns as required reserves. So excess reserves become required reserves while at the same time the money supply increases by about ten times the amount of the reserves.
That's all well an good, but what if the banks had to withdraw excess reserves in a manner that doesn't replace them with required reserves? If a person goes to the bank and removes money in cash, reserves are reduced but not replaced. So hoarding of currency would upset the balance. That's not likely to happen unless there's a fear of bank failures way in excess of the deposit guarantee, or if the deposit guarantee was considered less dependable. That's a low probability; in fact, it's more likely that foreign countries will want to scrub their countries of greenbacks and return them to the USA because their value became increasingly suspect.
The abundance of excess reserves, which never before 2009 existed, creates several degrees of freedom that never previously existed. That complicates Fed control of monetary policy. A sudden change in the economy is most likely to be a surge in loans by banks which convert excess reserves to required reserves, with a concurrent explosion in the money supply and explosion in the inflation rate. Whereas the Fed has always had two tools to control money supply - the required reserve ratio and short term rates - this time it will have only one - short term rates. Reserves will be in such abundance that the reserve ratio will have no significance. Short term rates will have to climb much higher on the next cycle to compensate.
You seem to be confused between the effects of low interest rates and QE. They're not the same thing. Banks have lots of reserves that aren't being loaned out because banks have become more reluctant to lend and consumers more reluctant to borrow. This situation has led the Fed to use QE which involves expanding the money supply by the purchase of government bonds and mortgage bonds.
If the banks start loaning out their reserves more strongly the Fed will raise interest rates. If loan demand rises strongly rates will rise strongly. That is the nature of monetary policy. The situation now is tougher to control than in the past which is what happens when financial meltdowns occur.
During a press conference within the last year, Bernanke explained that there would be no sharp impact to interest rates with discontinuation of QE. Essentially, he said that the effect of QE was primarily based on the amount of securities that the Fed was holding, not their rate of purchase.
What happened last summer seems to have blown that theory out of the water.
Consider a scenario in which QE is effective. Ten year rates climb to 4%, and the Fed is holding $3 trillion of treasury securities against $3 trillion of excess reserves, which are worth (on average) 15% less. The Fed doesn't mark to market, so as long as the banks never call back their excess reserves, it's OK.
Now say the Fed wants to reverse QE. It could sell all the securities it's holding, but that would leave $450 billion in excess reserves against which there are no assets, placing the balance sheet out of "balance." I guess the banks couldn't actually access those excess reserves, but yet the banks are undoubtedly considering those reserves as a solid asset. I hope they never need them, else they would find that they are no more solid than RMBS in 2009.