Saturday, August 17, 2013

Tight money has already begun

Aside from the fact that the 10-Year Treasury Yield Index (TNX) is rising, another reason for the latest equity market sell-off is the uncertainty generated by the Fed’s recent announcement.  

At its latest press conference, Fed Chairman Bernanke indicated the central bank could start winding down its $85 billion/month asset purchase program known as QE3 as soon as next month.  This has understandably caused a certain amount of consternation on Wall Street, especially given the feeling among many traders that QE has been largely responsible for the stock market’s rebound. 

What many investors don’t realize is that the Fed’s monetary stance has already tightened even before the “tapering” begins.  Author Ramesh Ponnuru, in his National Review article entitled “Cause for Depression,” points out that by merely telegraphing its intentions, the Fed creates expectations for future money conditions.  This in turn reverberates through the financial system well ahead of actual changes in Fed money policy.  

“When the Fed creates an impression about future spending levels,” writes Ponnuru, “it affects the spending that people undertake today in anticipation of that future.  So when the Fed suggests that it will pursue a tighter money policy in the future, it is effectively tightening money in the present.  Even when it cuts the federal-funds rate, it may be tightening money if markets had projected a sharper cut.”

Ponnuru went on to define tight money as “reduced expectations of future spending.”  That’s as concise and as practical a definition of tight money as you’ll hear.  His explanation of future expectations for money conditions fully explains what’s happening right now with the bond market and the stock market.