The Federal Reserve Taper Begin

The Federal Reserve Board has made its long-awaited announcement that it will begin to scale back ("taper," in Wall Street language) its QE3 stimulus program.  The last time the Fed even mentioned starting to taper back, last fall, global stock markets and bond investors panicked and sent the markets reeling.  Now, the Fed says that instead of buying $85 billion in Treasuries and mortgage bonds per month, it will only buy $75 billion, and more cuts will come as the economy continues its recovery and the jobless rate continues to fall. 

With this announcement, markets went up and investors cheered.  Japan's Nikkei index reached a six-year high, European markets soared and U.S. stocks finished the day at new record prices.

Does any of this make sense to you?

The so-called "taper," and the QE3 stimulus program itself, are somewhat unique in the history of investment markets.  To understand QE3, imagine that at the auctions where investors buy government bonds and packages of home loans, a bidder nine times the size of Gargantua shoulders everybody else aside and insists on paying higher prices (and, therefore, receiving lower interest) than any of the other bidders.  The Fed's stated goal was to stimulate the economy by driving interest rates lower, making it less expensive for large and small businesses to borrow money, so they can build factories, expand their capacity and hire more people.

The problem with this stimulus effort was two fold:

1. Many American corporations were already sitting on tons of cash, and have little need to borrow if they really wanted to go on a building and hiring spree.  The companies in the S&P 500 index reportedly have a record $1.5 trillion in their coffers, up 14% this year alone.  Add in the money stuffed under the mattresses of some smaller companies, and the total may exceed $5 trillion. 

2. The Fed kept interest rates so low that banks did not want to loan money to small businesses and/or people who did want loans.

The Fed's mortgage purchases probably did make mortgage rates a bit cheaper for home buyers, but it's hard to tell how much.  The day after the announcement, 30-year Fannie Mae mortgage rates were up 0.01 percentage point, at 4.42%.  That's higher than the low of 3.31% in November of 2012, but still very low by historical standards.

Savers and long-term investors should breathe a sigh of relief that the Fed is finally easing out of the investment business.  Why?  For one thing, it means that economists at the Federal Reserve Board believe the economy is finally in a self-sustaining recovery mode. 

For another, it means the end of uncertainty.  When investors are unsure what to expect, they tend to expect the worst. Which is why you will read articles saying that the taper could cause interest rates to skyrocket leading to some problems with the value of ETF & mutual fund bond investments currently owned by investors. But admittedly by early indications, no such thing is happening right now, and you can bet that Fed economists are monitoring the situation and will try to nip any such problems in the bud.

At the same time, we can expect interest rates to go up over the next few years. This could be a problem for some bond ETF or mutual fund holders, but it is great news for older Americans who have been living on CD interest rates that are barely higher than what they would get if they stashed their retirement money in a cookie jar. 

For the economy as a whole, there is still plenty of cash to lend to any company that wants it if it becomes profitable to do so, housing is still more affordable than it was before the 2008 meltdown, and inflation is still currently stubbornly lower than the government's preferred target rate. All in all we are ending 2013 on a great note. However, I will personally be moving into 2014 with a little caution.

Behavioral Finance

One of the most interesting areas of financial research these past ten years has come, oddly, not from economists or investment researchers, but psychologists, who are pioneering a branch of study known as "behavioral finance."  This has led to one of the strangest sights in the history of Nobel prizes: the 2002 prize in economics handed out to psychologist Daniel Kahneman for (according to the Nobelprize.org website) "having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty."

The behavioral finance research tells us that most people take mental shortcuts to arrive at decisions, and some of them lead to odd conclusions.  Around the time you make your New Year's resolution to lose weight, do you buy a $500 annual membership to a gym or opt for a $10 per visit pay-as-you-go fee?  Most people who choose the former end up actually going to the gym less than once a month; the flat fee is only a bargain when you assume that the bold post-resolution intention will actually happen, but it's often a terrible deal when a person's actual behavior is taken into account. 

How do you decide whether to be an organ donor when you face the option on your driver's license application?  In countries where the default option is yes (you consent to be an organ donor), 90% of individuals happen to be registered organ donors.  In countries where the default option is no, the percentage ranges from 10% to 30%.

This research is now finding its way into the hands of policy makers, who are pioneering a new governmental role of protecting you against the dangers of your own mental shortcuts.  One recent example is automatic enrollment in a company retirement plan.  Research shows that if people are required to affirmatively opt-into having a portion of their paycheck sent to their 401(k) retirement plan, they will do so at a lower rate (67%) than if they are enrolled by default and have to affirmatively opt-out (77%).  The U.S. government has been encouraging auto-enrollment policies at American corporations, on the theory that workers will be better off if more of them are making regular 401(k) plan contributions.

Another example in Britain came when the government offered tax incentives for people to insulate their attics, reducing energy consumption and the associated pollution from energy production.  But so few people showed an interest in the incentives that the UK government finally had to switch tactics.  It offered the same tax break, but added a loft clearance service that would help people clean out their attic and give them assistance in disposing of (sell or throw away) unwanted items.  The new service tripled insulation participation rates. 

When the city of Copenhagen painted green footprints on the sidewalks leading to  litter bins, littering decreased by 46%.

The idea of applying behavioral economics to political and social initiatives sounds a lot like manipulation to its critics, who worry that we are moving toward a "nanny state" where the government feels compelled to protect us from our own behavioral biases.  Reducing litter on the streets of Copenhagen is relatively noncontroversial, but what about initiatives that try to influence buyers to select more energy-efficient cars?  Or government policies that discourage the consumption of certain foods or beverages?  The New York City ordinance against large soda containers was based on the assumption that people were unable to recognize, on their own, the health risks of soda consumption.

Interestingly, at least one of these behavioral initiatives is now showing evidence of backfiring.  The Center for Retirement Research at Boston College found that companies that have switched to automatic enrollment in their 401(k) plans have been paying for the additional cost by giving their employees smaller employer matches--3.2%, compared with an average 3.5% for plans without automatic enrollment.  At the same time, the Boston College researchers and the Vanguard organization have found that for some workers, the automatic savings rate offered in the default is lower than what many workers would have chosen if they had made an affirmative decision to participate.  Worse, the automated mix of investments (typically target date funds) that is the default option has underperformed the investment mixes that workers have tended to select on their own.  For some workers, at least, the government's behavioral finance nudge will cost them real money.