Why the Fed's 'Taper Tantrum' Doesn't Matter

BALTIMORE ( Stockpickr) -- The hysteria surrounding the possibility that the Fed would turn off the spigot became palpable in yesterday's trading session. On Thursday, the S&P 500 index closed 2.5% lower than it opened, posting the single-worst trading session for the big index in 2013 -- and the worst since November 2011, in fact.

Ouch.

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Perhaps more significant, yesterday's S&P 500 decline pushed the big index to close below its 50-day moving average, a line that's acted as crucial support over the course of this orderly rally. If there's a single word to describe how investors feel right now, it's "panicked."

But the Fed's taper tantrum doesn't matter. If you think that Chairman Bernanke's checkbook is slamming shut in 2013, you're wrong. And the implications remain the same for stocks: higher ground.

Most people have the cause and effects of quantitative easing flip-flopped. Ask 10 investors what Bernanke is trying to achieve by buying up Treasuries and agency MBS, and you'll probably get 10 different answers. I'll give you a hint: It's not jobs, it's not GDP growth, it's not stock prices, and it's not even the obliteration of gold prices. Instead, he's targeting one thing: deflation.

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Or more specifically, he's targeting a pretty narrow definition of inflation, a 2.2% minimum in the Fed's 5-Year Forward Inflation Rate. (That's 0.2% higher than the Fed's stated 2% target for inflation.)

Take a look at how well that 2.2% level acted as signal to open the floodgates on another round of QE all the way through last year:

Every time the Fed's internal measure of forward inflation dipped below 2.2% between 2008 and 2011, the Fed announced a far-reaching new quantitative easing program. It was like clockwork. But then, something changed in 2012. Suddenly, Bernanke and company got more aggressive -- and more willing to launch new QE initiatives.

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As the chart shows, QE3 and QE4 were very different animals than the first three rounds of quantitative easing (including Operation Twist). But that makes sense. After all, each of the first three rounds were a stop gap designed to keep the economy from the perils of deflation. With QE3 and QE4, the Fed was giving the economy a shot in the arm, hoping to jumpstart an uptrend in inflation before it got to that precarious point.

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