Those who’ve seen Francis Ford Coppola’s “Apocalypse Now” will recall Robert Duvall’s air-cavalry colonel (and surfing enthusiast) by his declaration of love for “the smell of napalm in the morning….smelled like…victory.” Since then, few people have been similarly associated with the power of things dropped from the sky (metaphoric or not) so much as Fed Chairman Bernanke, whose famous remark referencing Milton Freidman’s concept of countering deflation via a “helicopter drop” of money earned him the nickname “Helicopter Ben.” That moniker has only been reinforced by the money creation and Fed balance sheet expansions of the central bank’s Quantitative Easing programs.
However, back on May 22, when Bernanke didn’t rule out some so-called “tapering” (he didn’t actually use that term) of the Fed’s asset purchases as early as this coming September, the fixed-income market has behaved as if he’d called in an airstrike. Indeed, the sell-off seemed to motivate some of Bernanke’s colleagues on the FOMC (as well as the big man himself) to at least project the appearance of walking back the incendiary comments, emphasizing that the decision process on tapering would be data driven and even implying that weak numbers might move the central bank to increase purchases. Case in point: the equivocation evinced in the July Fed minutes released yesterday.
This uncertainty is understandable in the face of less than robust indications of economic expansion, e.g., second-quarter GDP growth of 1.7%. Moreover, inflation continues to be subdued, begging the question of why Bernanke & Co. would choose to discuss reining in bond buying now.
Perhaps one hint is to be found in the yield spread between Treasuries and the inflation-indexed variety known as TIPs. An indicator of market expectations of future inflation, the ten-year TIP spread has widened from near zero in late November 2009 to around 2.15% as of this writing. While in excess of the 2% rate the FOMC has generally acknowledged to be their current target (though some have indicated a willingness to consider a range about this figure), the problem is that as the taper rhetoric has increased, the TIP spread has been contracting. As can be seen from the accompanying graph (with Fed assets expressed as a fraction of their 1/2/2008 value), even as Fed asset growth accelerated in 2013, the central bank has struggled to increase inflation expectations, with the TIP spread maxing out at 2.59 this past February before beginning its fall to current levels. To be sure, by many measures actual inflation has increased since its post-crisis lows, but with the Core Personal Consumption Expenditure price index (the Fed’s preferred measure of inflation) still running at only 1.22%, neither current inflation nor expectations give the Fed vast breathing room.
Meanwhile, recent job creation figures have been only modestly solicitous, with a stubbornly low participation rate even as employers confront incentives to move full-time workers to part-time status under health care reform. The prospect of coming quarters is also haunted by the specters of fiscal drags from the delayed effects of sequestration and increased taxes.
Of course, regardless of the economic statistics, the Chairman could be forgiven for wanting to put in train at least a reduction in the rate of Fed asset purchases so as to indicate the will to deal with the central bank’s massive and growing balance sheet before leaving office, let alone prior to a more meaningful increase in inflation or fall in the value of the dollar. After all, the Fed’s assets now stand at over 20% of the national debt, and the central bank current bond purchase rate has it pretty much buying up the entire Federal deficit this year, raising fears of monetization (see “Uncle Ben’s Reverted Price”). Yet with unemployment still high, corporate profits decelerating and even the hint of tapering having caused mortgage rates to spike, there is a serious potential for taper-induced economic deceleration. Given that inflation is at best just nudging up into its perceived target range, if any Fed taper is followed by a fall in growth it may be difficult for Bernanke or his successor to justify meaningfully dialing back quantitative easing. Even as far from the ocean as Jackson Hole, FOMC members gathered without their leader must feel the alternatives are a bit like the choice Duvall’s colonel gave his men: engage in a firefight or attempt to surf under an artillery barrage.