It’s the central bank’s fault! This common refrain has grown louder as Fed Chair  Janet Yellen engages in some of the most delicate maneuvers that a central bank has ever attempted. With the economy generally moving along at a reasonable if slightly awkward clip – unemployment is abnormally low, but income inequality is abnormally high – central banks around the world have been nonetheless engaging in unorthodox economic stimulation. Now the Fed is attempting to withdraw the quantitative stimulant, a dependent substance, from the market cycle. This could result in unwanted volatility with one slight misstep. Not only is Yellen’s surgical task unique in history, but the first female fed chairman has an increasingly vocal gallery heckling her as the central bank makes its move. 

Blame it on the Fed

“It’s the Fed’s fault,” writes Paul Mortimer-Lee, Chief Market Economist and Head of US Economics at French giant, BNP Paribas. Such a statement requires multiple points of understanding: What economic outcome did the Fed get wrong, what is the impact and what is the time frame on the disaster? In a October 12 report, “the bank for a changing world” as their brand moniker suggests sees the problem. Mortimer-Lee has seen the enemy, and it is low inflation.

There is a linear, cause and effect relationship between when the Fed began to “taper” its injection of dependent market stimulus into the system and when it started to raise interest rates. In a report titled “Blame the Fed for low US inflation,” Mortimer-Lee does just that and more.

“Since everyone knew that rate hikes could not start until tapering had finished, the act of tapering had a strong signaling effect,” he wrote. Some analysts have lauded the fed chairman Bernanke for being predictable while others have found it a liability. He thinks the initial May 22, 2013 taper tantrum was sending too much information. On this day the Fed announced it would begin reducing its nearly $70 billion a month in bond and mortgage-backed securities purchasing. “The news made risk assets the ugly duckling of financial markets,” Forbes noted.

The stock market, measured by the S&P 500, dropped from a near-term rolling average high of 1667 on May 17 to a trend channel low of 1592 on June 21. But then it recovered and is currently trading nearly 1,000 points higher in a little over four years. Such is the magic of quantitative easing.

On a subtler level the taper tantrum also correlated with a meaningful fall in inflation expectations. BNP would later be “very critical of the Fed ignoring the much tighter monetary conditions caused by the taper tantrum when deciding to taper later that year.”

Determining when to withdraw an addictive stimulant from the market’s bloodstream is never an easy decision, one fraught with downside risk. From the Fed’s standpoint, it has been a game of pinprick testing and then moving on. If market data begins to change after a Fed gyration, they have tools at their disposal to smooth out the ride. At times this results in starting and then stopping again. “Once the Fed has been set on a course in this cycle, it has put its data blinkers on,” and there would be multiple such occasions.

“Despite only four hikes in just under two years the Fed has subdued inflation expectations and therefore inflation,” he wrote, pointing to two factors that don’t always show a 100% correlation. “The Fed’s rhetoric has constantly been about raising rates, from way too early in the cycle and its rate hikes have too often been path dependent rather than state dependent. The FOMC has too often ignored inflation when hiking. When fed chairman Bernanke started the taper tantrum, core PCE inflation had descended from 2% in early 2012 to 1.4% – no wonder the market took fright. In the six months preceding the first hike, core inflation averaged only 1.3%.”

And the S&P 500 nonetheless rose near 1,000 points from the first point of inflation. That’s an inflation that perhaps Mortimer-Lee can live with, however.