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Long bull market in Fed faith faces taper: James Saft

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(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

(Reuters) - For the first time in more than three decades we may be entering a period of declining faith in the Federal Reserve.

If the Fed does begin to taper in coming months, slowing its bond purchases as many expect, it will mark a tacit acknowledgment of the limits of the power of monetary policy. By extension, it would also mark a decrease in the power or willingness of the Fed to control the prices of financial assets.

This realization - that the Fed can't always play Santa Claus and FOMC day isn't a sort of secular Christmas - will hit investors hard.

On the evidence, this realization is already dawning.

Gold jumped by 2.37 percent on Thursday, while the dollar fell and government bond interest rates continued to march higher. Ten-year Treasury yields touched 2.76 percent for the first time since July of 2011. At the same time the S&P 500 index fell by 1.4 percent.

Conventional wisdom on Thursday was that bond yields were rising and stocks falling because new economic data made a September taper more likely. Jobless claims last week did fall to close to a six-year low, while consumer prices rose by a small but meaningful amount in July. That's significant, especially the inflation, as the low and falling inflation we've had seemed to call for more stimulus rather than less.

"Are we at the low water mark for inflation? Maybe, and if the Fed even suspects this is the case, they will be even more eager to end asset purchases and normalize policy," Tim Duy, an economist at the University of Oregon and noted Fed watcher wrote in his blog. (http://economistsview.typepad.com/timduy/2013/08/fall-tapering-in-the-ai...)

"Bottom Line: The realization continues to grow that whether it is September or October or December, the end of asset purchases is now in sight."

Now if the Fed tapers because it has succeeded, then the logic holds that a taper is bad for financial assets but the central bank retains its ability to use policy to drive prices in the direction it wishes to affect the economy. That is a bedrock belief for many investors, allowing them to sleep well at night secure in the notion, however false, that the financial universe is run by a benevolent power which tends to err on the side of asset owners.

A NEW WORLD

You can hardly blame them for believing that, indeed the last 30 years have conditioned investors so that they do.

Things, however, are a bit more complicated. While retail sales in aggregate have been fine, if not compelling, recent earnings from Wal-Mart and Macy's appear to point to a U.S. consumer taking the month of July off. At the same time, industrial production is going sideways, and the Philadelphia Fed index of general business activity in the mid-Atlantic region more than halved in August from July, to just a 9.3 reading. New orders halved and shipments actually contracted.

All of this points to a Fed which is thinking longingly about taper despite a signal lack of success of its extraordinary monetary policy. And while the central bank stresses that a tapering isn't a tightening, higher interest rates make that harder and harder to swallow.

Remember, a tapering may occasion the first significant market reversal in many years brought on by the Fed wittingly, as opposed to by accident. Not that the Fed wants markets to go down, but rather that it may finally feel that the risks and costs of a pro-financial asset policy outweigh the benefits.

This would be something entirely outside the experience of most working investors and analysts. It will come, if it does, as a big shock.

Think of the past decades - the Long-term Capital Management bailout, the dotcom bubble, the aftermath of the dotcom bubble, the housing bubble and finally, the "rescue" of the economy in the wake of the financial crisis. All of these included as a central feature Fed policy which tended to indulge market runs and attempted to soften market falls.

None of this is to say that the Fed's ability or commitment to fight inflation is in doubt, only the widespread faith in it as an institution which can somehow magic into being excellent returns for investors, while standing by to clean up their messes.

This change in market psychology will be, on the whole, a good thing.

It will, however, tend to push downward swings in risk assets a bit harder. This leads to the next question: if the Fed tapers and the market swings down violently, will it return to form and seek to cushion once again?

If so, the Fed may find its credit with investors all tapped out.

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

http://www.globalpost.com/dispatch/news/thomson-reuters/130815/long-bull-market-fed-faith-faces-taper-james-saft