The Fed has decided to taper its quantitative easing policy by $10 billion per month, to $75 billion. Chairman Ben Bernanke expects the program to wind down steadily through 2014 and conclude by year-end, assuming the economy remains healthy. See the details of the decision here.
What is Fed Tapering?
“Tapering” is a term that exploded into the financial lexicon on May 22, when U.S. Federal Reserve Chairman Ben Bernanke stated in testimony before Congress that that Fed may taper - or reduce - the size of the bond-buying program known as quantitative easing (QE). The program, which is designed to stimulate the economy, has served the secondary purpose of supporting financial market performance in recent years.
While Bernanke's surprising pronouncement led to substantial turmoil in the financial markets during the second quarter, the Fed did not officially announce its first reduction in QE until December 18, 2013, at which point it reduced the program to $75 billion per month from its original level of $85 billion. The reason for this move was that the economy had become strong enough for the Fed to feel confident in reducing the level of stimulus.
Currently, the consensus estimate is that the Fed will continue to reduce the size of its QE program through 2014 and ultimately wind it up by the end of the year. However, this isn't necessarily a guarantee given that 1) the program is data-dependant and 2) both the Fed chairmanship the several board positions will change early next year. As a result, both the timing and extent of the QE withdrawal remains uncertain.
("Data dependant" means that weak growth would lead to a continuation of quantitative easing, improved growth and/or rising inflation would prompt the Fed to continue the program's reduction).
That same day, the minutes of the Federal Open Market Committee – or FOMC, the committee that sets monetary policy – revealed that support for QE is by no means unanimous:
“Participants also touched on the conditions under which it might be appropriate to change the pace of asset purchases. Most observed that the outlook for the labor market had shown progress since the program was started in September (2012), but many of these participants indicated that continued progress, more confidence in the outlook, or diminished downside risks would be required before slowing the pace of purchases would become appropriate. A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome.”
For a full,
up-to-date explanation of Fed policy, see Current Federal Reserve
Policy: A Layperson’s Explanation
Bernanke followed up his previous statements in the press
conference that followed the Fed's meeting on July 19. While
stating that the quantitative easing policy remains in place for now, the Fed
Chairman also the policy remains dependant on incoming data. Given the
improvement in the U.S. economy, he expects this data-driven approach will
prompt him to begin to taper QE before the end of 2013, with the program ending
entirely in 2014.
With this as background, the markets expected the tapering to
occur at the Fed's September 18, 2013 meeting. However, the central bank
surprised the markets by electing to keep QE at $85 billion per month. This
shift was likely caused by two factors: 1) a string of weaker economic data
that had been released in the prior month and 2) the prospect of slower growth
stemming from the oncoming government shutdown and debt ceiling debate.
How Will a Tapering Look?
Tapering isn’t an immediate, dramatic event. Instead, it is
likely to take place gradually throughout 2014 so as to create minimal market
disruption. Also, it is going to remain dependent on economic conditions. The
Fed may pull back slightly if the economy continues
to strengthen, but it could also increase the program again if the economy
slowed or the financial markets were shocked by an unforeseen crisis.
Tapering Shouldn’t Come as a Surprise
The potential for
tapering has existed since QE began. Quantitative easing was never intended to
last forever, since each bond purchase expands the Fed’s “balance sheet” by
increasing the amount of bonds it owns. Also, in past communications Bernanke
had made it clear that the continuation of the program was dependant on
incoming economic data.
Bernanke in fact
maintained this approach in his May 22 testimony, saying “A premature
tightening of monetary policy (i.e., a tapering of quantitative easing) could
lead interest rates to rise temporarily but would also carry a substantial risk
of slowing or ending the economic recovery and causing inflation to fall
further” and “I want to be very clear that a step to reduce the flow of
purchases would not be an automatic, mechanistic process of ending the program.
Rather, any change in the flow of purchases would depend on the incoming data
and our assessment of how the labor market and inflation are evolving.”
Market Reaction to Tapering
While Bernanke’s tapering
statement didn’t represent an immediate shift, it nonetheless frightened the
markets. In the recovery that has followed the 2008 financial crisis, both
stocks and bonds have produced outstanding returns despite economic growth that
is well below historical norms. The general consensus, which is likely
accurate, is that Fed policy is the reason for this disconnect. Once the Fed
begins to pull back on it stimulus, the markets may begin to perform more in
line with economic fundamentals – which in this case, means weaker performance.
Bonds indeed sold off sharply in the wake of Bernanke's first mention of
tapering, while stocks began to exhibit higher volatility than they had
previously. The markets subsequently stablized through the second half of 2013
as investors gradually grew more comfortable with the idea of a reduction in
QE.
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