There has been a lot of talk about the Fed "tapering" over the last few months. It has been a concern for financial markets, particularly the bond market, which has seen the 10-year yield rise close to 3%. While I think the Fed may "taper" a bit, I don't think we will see anything close to a stable monetary policy. Perhaps the Fed will stop inflating for a short while, but it won't last long.
The correct policy would be to allow competing currencies and gradually replace the Fed with a free market in money. Absent getting rid of the Fed, the correct policy is for the Fed to stop inflating. This will cause a major correction and some short-term pain for many. But this is what needs to happen for real and significant economic growth to happen again. It would be better to deal with the short-term pain than to continue the problem and make things even worse in the future. With that said, I don't think the Fed will adopt a monetary policy in the short run that will be beneficial for the economy. I think the Fed will continue with its monetary inflation for a while.
There are 3 main reasons that I think the Fed will continue with its so-called quantitative easing. They are as follows:
- The consumer price index (CPI) has stayed relatively low. In a truly free market environment, we would likely see a consumer price index that actually gradually declines. This would reflect an increase in productivity, such as what we see in the electronic industry. But compared to the late 1970's, the CPI is relatively low. While even 2% is higher than it should be, and while the index may be flawed, the Fed will use this metric as an excuse to continue its loose monetary policy. As long as high inflation is not being perceived by the general public, then the Fed has a green light to continue with its monetary inflation. I believe this is the one metric that could cause the Fed to eventually stop its money creation. If price inflation starts to get out of control, I don't think the Fed will risk hyperinflation. But as of right now, the CPI is relatively low and the Fed will even cite this as a reason for more QE.
- The economy is still in bad shape. We can hear all of the rosy speeches from Obama and Bernanke all day long, but people know that things are bad. In reality, things would be much better right now if the Fed had pursued a better monetary policy since 2008. Things would also be much better if the government were not spending so much money and misallocating resources on such a grand scale. But since unemployment is still high and the middle class is feeling the pinch (along with poorer people), the Fed will cite this as a reason to continue its QE, even while saying that things are improving.
- The big banks still need to be bailed out. The Fed bailed out the big banks in 2008 and has been doing it again since last year. It has been buying mortgage-backed securities and paying a price that is above market value. The balance sheets of the major banks are still not good. But they are better than they would be had the Fed not engaged in its purchases of $40 billion per month of MBS since September of 2012. The Fed cannot get away with a bailout like what happened in the fall of 2008. Public opinion is too much against it. So the Fed resorts to tricks. It bails out the banks by buying the bad assets of the banks. The primary purpose of the Fed is to keep the big banks afloat. It will not give up on this mission. As long as the public is deceived and the Fed can use QE to bail out the banks, why wouldn't it keep doing it this way, instead of causing a public uproar?
In conclusion, I don't think the Fed is going to give up on QE anytime soon. It may pull back for a while, but there are too many reasons for it to keep going right now. I think a dramatic rise in the CPI is the only thing that will stop the monetary inflation at this point.