Recent headlines that the Federal Reserve is contemplating tapering its bond buying (QE or Quantitative Easing) program have dominated the news flow. Our focus for this investment letter is to highlight what tapering is and the potential consequences of such actions. In recent years the Fed, independent of government, has provided support for the economy by buying bonds to keep interest rates low. “Tapering” means that the Fed will begin slowing the rate at which it purchases bonds. What is interesting about Bernanke’s comments is that the impetus to begin to reduce bond buying is data-dependent.

For that reason, we have adopted a wait-and-see approach:

• If economic fundamentals begin to show added strength, then fewer bonds would be bought. Let the tapering begin!
  
  
• If the fundamentals telegraph continued sluggish underlying performance of the economy, tapering will be on hold.

Absent perfect execution from the Fed, what are the consequences of the Fed’s tapering? We base our answer on the assumption that tapering will begin either too early or too late. It is our view that the Fed will err on the side of being too late. A recent table, adapted from Ned Davis Research Group, right, highlights the overall benefits and costs/risks of Quantitative Easing or QE.

In our view, if tapering begins too early, the benefits stated in the table do not get fully realized. Namely, the housing market recovery stumbles and consumers reduce their spending as a sign of decreasing confidence. If tapering begins too late, which is our base case, then the costs and risks highlighted on the right become more real. The biggest concerns, among others, are to avoid creating new asset bubbles (e.g., the U. S. housing market 2002-07), higher inflation and a possible currency war. To borrow a cricket analogy, clearly the Fed is in a sticky wicket.

About Caldwell Trust Company 

Caldwell Trust Company is an independent trust company with offices in Venice and Sarasota, Florida. The company offers a full range of fiduciary services to individuals, including services as trustee, custodian, investment adviser, financial manager and personal representative. Additionally, Caldwell manages 401(k) and 403(b) qualified retirement plans for employers.