Fed's Taper Will Have Negligible Impact On Economy

I recently wrote "Economic Forecast After The Federal Reserve Starts To Taper." Now that the Fed has decided to taper, I am NOT changing my economic forecast.

Key points:

QE3 has had little effect on the economy, though there may be some lagged impact in 2014.

Tapering is not tightening; in metaphorical terms, the Fed is not hitting the brakes, just easing up a small amount on the gas pedal. In the chart, the red area is a projection assuming that the Fed continues its new level of purchases through the end of 2014. In reality, another taper is more likely than not, but I show the path of the new purchases to offer a picture of the magnitude of the change.

The Fed is tapering because the economy is showing moderate strength. The Fed's action will not sink the economy.

As for financial markets, maybe markets had been fearing a more pronounced taper and are relieved that this is so minor.

As I wrote before, a look at the data shows how little impact quantitative easing has had on the economy. In the graph at right, quantitative easing is shown by Federal Reserve Credit. I’ve made the line thicker where the three rounds of quantitative easing occurred. In red I show the growth rate of inflation-adjusted gross domestic product. GDP growth is bumpy, not smooth, but I think I can see some quantitative easing.

A few quarters after the first round of quantitative easing, QE1, GDP growth surged. That’s consistent with Milton Friedman’s conclusion that the time lags of monetary policy are long. However, it’s pretty common for GDP to surge in the first few quarters after a recession, so maybe it would have happened without quantitative easing.

QE2 began in late 2010 and probably triggered the stronger growth a year later—long time lags, remember. So far we have seen little impact from QE3, but the time lags are long, so perhaps we are in for stronger growth in 2014 because of the stimulus. But perhaps not.  Both QE1 and QE2 pushed up money supply growth dramatically. QE1 doubled the M2 growth rate, and QE2 had an even great impact. Since QE3 started, though, money supply growth rates have gradually declined. This indicates that the stronger bank reserves have simply been held by banks, not lent out to businesses or consumers.

It’s also clear that quantitative easing is not the great driving force of the economy. In the interludes, the economy did not plummet. The size of these reserve credit increases is huge by historic standards. It’s amazing that they did not send the economy into the stratosphere.

If the Fed were to suddenly suspend QE3, I doubt that the real side of the economy—spending, production and employment—would show much impact.