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Fed Will Taper Later This Year, But Not for Obvious Reasons: Bill Gross

Fed Will Taper Later This Year, But Not for Obvious Reasons: Bill Gross

By Rick Newman

The billion-dollar question on Wall Street is this: When will the Federal Reserve begin to rein in the aggressive monetary stimulus program known as “quantitative easing?”

Fed Chairman Ben Bernanke got the guessing game started on May 22 when he told a Congressional committee the Fed could begin to scale back QE “in the next few meetings” if the economy continues to improve. Bernanke seemed to be saying the Fed could begin to roll back QE by the end of 2013, even though many investors had been expecting the program to remain at full strength until sometime in 2014.

The uncertainty caused by Bernanke’s remarks triggered a modest stock selloff, with interest rates on the benchmark 10-year Treasury bond rising about half-a-percentage point during the past month. Under QE, the Fed purchases about $85 billion worth of Treasury securities and other bonds each month, which pushes interest rates down (the Fed is basically reducing the supply of bonds, allowing those who issue them to pay lower rates to borrow). Lower rates, in turn, are one reason more investors have been buying stocks, hoping to get higher returns. So if the Fed were to reduce its bond purchases, the opposite might happen, with interest rates rising and stocks falling.

That’s one theory, anyway. Investment guru Bill Gross, founder and co-CIO of the huge investing firm Pimco, has another theory. As Gross told Aaron in the video segment above, he thinks the Fed will have to “taper” its bond purchases by the end of the year for a different reason: Lower deficits in Washington mean the Treasury will issue less debt, which could create a shortage of Treasury securities if the Fed continues QE at its current pace.

“It creates a problem … if the Fed owns all the Treasuries,” Gross said. “Then there is no market for the bonds. So I think at some point they’d taper if only to permit the rest of us to have a few.”

Gross still doesn’t think the economy is strong enough to stand on its own, without support from the Fed. But he has also derided quantitative easing as “chemotherapy” that may do more harm than good. Gross cites three side effects of QE that could be distorting the economy and holding back growth. First, super-low interest rates discourage saving, leaving less money available for investment. Second, financial firms that rely on more normalized interest rates for income are less profitable, which means they hire fewer workers. Finally, low returns on investment discourage companies from deploying capital in the real economy, contributing to lower growth and fewer jobs.

Still, it’s highly possible the economy would be in even worse shape without QE, which seems to have helped speed a housing recovery as well as stimulating a stock market rally that’s entering its fifth year. The latest jobs report, for instance, showed that employers created 175,000 new jobs in May, which is not a robust pace of hiring but is better than many economists expected just a few months ago, when it seemed as if tax hikes and spending cuts in Washington might squash hiring for months.

With an elevated unemployment rate of 7.6%, however, many analysts think the Fed will keep QE in place longer than recent market moves suggest. Bank of America Merrill Lynch is telling clients the Fed won’t cut back on bond purchases until April of 2014—nearly a full year from now. The only thing that might speed that up is a dramatic pickup in hiring during the next several months, which virtually no economists are predicting.

Markets could remain bumpy, however, as anxious investors try to gauge the timing of a Fed pullback and Fed officials themselves contribute to the confusion through suggestive public comments.

“Tapering will come, but not until early 2014,” forecasting firm IHS Global Insight wrote in a recent analysis. “However, ongoing tapering talk by the Fed will likely result in more volatile stock and bond markets during the second half of 2013.” By the time the Fed actually does reduce its bond purchases, the move might be anticlimactic.

Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.