THE TAPER: Recalibrating Liquidity - By Richard Duncan

The “Taper” has begun. It’s important to understand why.

On December 18th, the Fed announced that it will begin to taper the amount of fiat money it creates each month from $85 billion to $75 billion starting in January. Chairman Bernanke also indicated that the Fed is likely to continue reducing the monthly amount of money it creates by $10 billion at each future FOMC meeting – so long as the economy performs in line with his current expectations. That would bring QE3 to an end by December 2014.

The press has attributed the Fed’s decision to taper to an improvement in the outlook for the economy. I don’t believe that is the correct explanation. The recovery is still too weak and uncertain to justify tapering on those grounds. In my opinion, the real reason is to prevent excess liquidity from creating a new, destabilizing asset price bubble in stocks and property.

During 2013, the Fed has injected just over $1 trillion of liquidity into the financial markets through QE. Over the same period, the government has sucked nearly $700 billion of liquidity out of the markets by borrowing to finance its budget deficit. That left $300 billion of excess liquidity that was invested into other asset classes, most notably stocks and property. On top of that, a further $400 billion of liquidity entered the United States from abroad as a surplus on the country’s financial and capital accounts. (See Macro Watch Fourth Quarter 2013 for a detailed explanation.) This massive excess liquidty explains why the S & P 500 Index and home prices are up 25% and 13%, respectively, this year.