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Taper effect: Here comes a bigger market correction

The Federal Reserve is reducing its large scale asset purchases (LSAP) during 2014, which will have some implications to the capital markets but will be meaningless to the economy and unemployment.

In order to predict what will unfold as a result of tapering, we first need to understand what it has accomplished. Remove this from the equation and you can predict the results. So, what are the implications of further tapering in 2014?


A trader works on the floor of the New York Stock Exchange.
Getty Images
A trader works on the floor of the New York Stock Exchange.

The purpose of LSAP and zero interest rate policy (ZIRP) over the last few years has been to stimulate the economy to create jobs — one of the Fed's basic mandates. ZIRP has had a positive effect: It has brought down short-term yields. This has benefited businesses and consumers who now are experiencing lower interest expense and it has benefited the equity markets as investors search for higher yields.

All this Fed action has made investors and Wall Street happy, but unless I missed it somewhere in the fine print, a frothy equity market is not one of the Fed's mandates.

The Fed is, in effect, a $3 trillion funds-flow stream into the capital markets that will be missed as tapering continues. How much it will be missed we do not yet know, but if the recent 4-percent correction can be used as a gauge, we have another 13 percent or so correction in store.

(Read more: 'Ugly correction' coming: Dennis Gartman)

With respect to improving the economy and easing unemployment, LSAP is a big zero — and for a reason. The Fed's mechanism to stimulate the economy is to make more money available for banks to lend by increasing the reserve funds the banks have. They do this by buying bonds owned by banks so the banks now have cash reserves.

Banks loan these reserves out, which end up as deposits at other banks, which then lend them out and the cycle continues. This money-multiplier mechanism can take $1 deposit and multiply it in the economy. This multiple has averaged 8.2 times over the last hundred years but now stands at a historic low of 3.0. Bank lending has grown at only 2 percent in the last year.

The outcome of all this LSAP has been to show that there is now little relation between the Fed's balance sheet and the M2 money supply (cash, checking deposits, savings deposits, money market funds, etc.) — there is a breakdown in the traditional mechanism of controlling money supply.

(Read more: Market strategists: Don't overreact here)

As a further indicator of stagnation, and just as important as the money multiplier is the velocity of money: the speed of money through the economy. The simple calculation of gross domestic product (around $17 trillion) divided by M2 money supply (around $11 trillion) gives us a velocity of nearly 1.6x. This is the lowest velocity in over 60 years.

So, the job of the Fed is to increase lending and increase the velocity of money. So why hasn't LSAP, quantitative easing and ZIRP worked?

The first reason is the Fed itself. As explained in a release by the New York Federal Reserve, the Fed historically did not pay interest on reserves held at the Fed. This changed in 2008 and the result has been that banks are living with the interest they are receiving on reserves rather than lending. It seems that higher interest rates they could earn with commercial loans are not worth the risk.

Even Bill Dudley, President of the New York Fed recently said, "We don't understand how LSAPs work to ease financial-market conditions — is it the effect of purchases on the portfolios of private investors, or alternatively is the major channel one of signaling?" His point is that the equity markets have responded well but other than that, all this LSAP is nothing more than "signaling" from the Fed. I, for one, have no idea exactly what they are signaling except that maybe they are signaling that LSAP and ZIRP will end someday.

One of the major economic headwinds we face, and a primary reason there is little demand for debt, is the level of total debt in the United States. Research shows that economic growth slows when total consumer, business and government debt exceeds 275 percent of GDP. It hit 375 percent in 2008, though it has since dropped to 345 percent.

Our focus needs to be on growing business debt because this debt increases economic activity since businesses generate a return on the debt while consumer debt simply accelerates purchases to today and slows them in the future. ZIRP has had an effect here as the cost of debt to businesses has declined dramatically since 2008, but there is still very slow growth in business demand. As we have seen in Japan, these excess debt levels create an economic headwind that lasts for decades.

(Read more: Surprising sign of growth ahead for US economy)

Meanwhile, the economic effects of the 2013 tax increase of $275 billion are just beginning to creep into the economy. We will see the effects in 2014 and 2015. Taxes have a negative multiplier of 2 to 3, meaning that they will slow the economy $550 billion to $825 billion.

The Obamacare employer mandate will kick in this year and no one knows what effect it will have on the economy, but it won't be good. We know that many employers will reduce employees or convert full-time employees to part time. Many will not provide insurance and force employees onto exchanges, hurting consumer economics.

Couple all this with changing demographics of baby boomers retiring and you have a recipe for slow economic growth for decades. Further, Europe is similarly engaged in over-borrowing and deficit spending by governments and most countries there have debt-to-GDP ratios similar to ours.

Consequently, they will also be faced with slow growth economies for decades. Low demand for debt and slow economic growth will keep inflation in check, which is good. The downside is high unemployment for decades, which is bad.

So, what is the Fed to do to get higher economic growth and lower unemployment? Inflate! They are certainly able to do so, as Ben Bernanke himself has pointed out, by purchasing assets outside of the banking system such as gold, ETF's and foreign bonds. Argentina and Venezuela are experts at this.

These "unorthodox" purchases certainly can create inflation and we know inflation creates economic growth and improves employment, two Fed goals. It is high time for the Fed to stop LSAP and try something else.

— By Murray T. Holland

Murray T. Holland is a 30-year veteran of the finance industry and managing director of Dallas-based MHTMidspan. He is also the author of "Nation in the Red" (McGraw Hill, 2013).

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