5 Reasons For The Fed To 'Taper' That Have Nothing To Do With Economic Data

Wall Street expects the Federal Reserve to announce the first reduction in the pace of monthly bond purchases it makes under its quantitative easing (QE) program at the conclusion of its FOMC monetary policy meeting Wednesday.

Right now, the Fed buys $45 billion in U.S. Treasuries and $40 billion in mortgage-backed securities each month - $85 billion of bonds in total - in a bid to stimulate the American economy. The consensus on the Street is that the Fed's first "tapering" of QE will consist of a $10 billion reduction in monthly purchases, bringing the monthly total to $75 billion.

The Fed has maintained ever since the tapering discussion began early this year that its decision to begin this process of winding down QE is "data-dependent" - in other words, as long as the economic data continue to show improvement in the health of the American economy, the Fed's plans for tapering remain on track.

Yet the data - especially in the labor market, where the Fed's focus lies - have been disappointing in recent months. The U.S. economy added only 169,000 workers to nonfarm payrolls last month, below consensus estimates for 180,000. July payroll growth was revised down to 104,000 from 162,000.

In reality, the Fed may have several reasons to begin scaling back QE that have little or nothing to do with improvements in the labor market, despite what the central bank says.

1. Frothy markets.

One is the risk of financial instability resulting from asset bubbles created by over-accommodative monetary policy. FOMC members flagged this as a potential issue in their April 30-May 1 meeting, according to the minutes from that meeting.

"At this meeting, a few participants expressed concern that conditions in certain U.S. financial markets were becoming too buoyant, pointing to the elevated issuance of bonds by lower-credit-quality firms or of bonds with fewer restrictions on collateral and payment terms (so-called covenant-lite bonds)," read the minutes. "One participant cautioned that the emergence of financial imbalances could prove difficult for regulators to identify and address, and that it would be appropriate to adjust monetary policy to help guard against risks to financial stability."

2. Effectiveness of QE.

Concerns over asset bubbles, in turn, could be changing the risk-reward tradeoff of further QE, given that the economy remains soft despite continued bond buying.

Goldman Sachs chief economist Jan Hatzius believes this may be the case, calling it the number-one driver of the coming reduction in QE.

"The main reason for this shift [away from QE], in our view, is that Fed officials now see asset purchases as less effective (and perhaps a bit more costly) than when they started the QE3 program," says Hatzius.

3. Bernanke's legacy.

Current Fed chairman Ben Bernanke's term at the head of the central bank expires in January, and at the White House, the search is on to find his replacement.

Bernanke is the Fed chairman responsible for introducing for first introducing QE as a policy tool to begin with - back in late 2008, when the banking system was in crisis and financial markets were in freefall.

QE has been something of a controversial policy from the start, and given the evolving views inside the Fed toward the risk-reward tradeoff of continued bond buying, Bernanke likely wants to be able to take credit for setting the central bank on a definitive course to reverse it before he leaves office.

"The announcement of 'taper' has NOTHING to do with the economy; it has everything to do with Mr. Bernanke's legacy," says Credit Suisse managing director Harley Bassman. "By stopping out the over-levered traders who were trying to monetize the 'Bernanke put', the FED has mitigated a 1994 or 1998 or 2007 scenario ... Mr. Bernanke does not want a Greenspan redux where a financial calamity occurs soon after his departure and he takes the blame."

UBS economist Drew Matus offers an argument along those same lines: "A move to taper QE in the fourth quarter would allow Bernanke's successor to simply continue existing policy rather than having to 'own' the move. The net result would be to minimize the policy uncertainty which typically taints markets during a transition."

4. Credibility.

The Fed has done a lot in the past few months to prime markets for this initial reduction in the size of QE. As a result, a tapering announcement at the conclusion of this week's FOMC meeting on Wednesday is now the consensus call on Wall Street, and markets have arguably priced in this scenario.

"There is probably something like a 'Keynes beauty contest' phenomenon here, whereby the market and the Fed may each try to guess what the other is guessing," says JPMorgan economist Michael Feroli. "With expectations cementing around $10-15 billion, the Fed is likely to deliver a taper of that size."

If the Fed fails to deliver this week, it could create additional uncertainty in markets as participants recalibrate expectations, with perhaps an eye toward a tapering announcement at one of the next two FOMC meetings in October and December, both of which would likely be more problematic given upcoming budget battles in Washington and the ongoing Fed chair selection process.

5. A shrinking deficit.

Regardless of how the budget battles in Washington play out, one thing is certain - the federal budget deficit is projected to continue shrinking, which means the Treasury will be issuing less and less debt to cover government spending needs as time goes on.

Federal Reserve purchases of government debt via quantitative easing already account for an overwhelming majority of new issuance from the Treasury, and if the central bank doesn't reduce the amount of bonds it is buying as the Treasury reduces the amount of bonds it is issuing, the Fed purchases will account for an even larger share of the market than before.

This, in turn, would necessarily mean a reduced supply of Treasuries available to other market participants. Because Treasuries - one of the few remaining AAA-rated financial assets on the planet - are used as collateral in a host of transactions throughout the financial system, continued Fed purchases at the current monthly pace as issuance declines could weigh on the financial system's ability to lend and lead to an increased risk of further destabilization in the Treasury market.