Fama on tapering–it all depends on your view of the Fed and the market.

Just watched a short clip on Zero Hedge with Ric Santelli and Eugene Fama discussing tapering.  Fama said that tapering would be a neutral event.

Fama’s point was that tapering is a simple balance sheet exercise whereby the Fed transfers the securities it has bought for the short term debt (deposits) it has issued.  I guess in a sense, if it is a neutral exercise, the impact would be determined by the interest rate differential on the two.  But it could be a lot more than this.

At the moment most of the money the Fed has created (its short term debt) lies on its balance sheet doing nothing more than earning interest.   Likewise the securities purchased by the Fed are doing nothing more than earning interest.  The net interest between the two has impact.

The neutral outcome depends to a certain extent on the overall demand and supply equation remaining constant.  That is if the Fed sells back securities in exchange for cash held on its balance sheet, will the holders of that debt wish to retain that debt and at what price will the holders of cash at the Fed be willing to swap for it?   Both risk impacting the price and the supply of debt and hence the risk free rate of return and the price of all assets in the market place.

But there is another factor, and that is the supply of debt – the flow as opposed to the stock.   New issuance of government debt may come under pressure if the market starts to hold too much debt and needs a higher return to hold that debt.   This could further impact markets, because the Fed has likely in truth been keeping rates stable in the face of the US governments own funding needs.  

The differentiating factor is that the Fed, the holder of excess debt and the issuer of short term debt (reserves) is a different kind of player and its holdings impact the market for debt and equities differently.   Expectations, will also be impacted and the expectation is that the Fed will no longer be supportive of markets.

If you believe in rationale efficient markets and that the Fed is but one more rationale efficient player, then nothing really changes and tapering has no impact.  But if you do not believe this, then tapering may have a large and significant unknown but material impact on the demand for and ability to supply debt and equities at current prices.

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