An Explanation of Fed Tapering and Its Impact on the Markets

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The Current Status of Fed Tapering

The U.S. Federal Reserve has finished tapering its stimulative quantitative easing policy. On December 18, 2013, the Fed began to taper its bond purchases by $10 billion per month, to $75 billion. After a series of reductions throughout 2014, the program concluded following the Fed's October 29-30 meeting.

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. The tapering continued on January 29, with the Fed announcing that the continued improvement in economic conditions warranted a reduction in QE, and the central bank remains on track to have the program wound up before year-end. The Fed has opted for this gradual approach is the Fed's desire to create minimal market disruption.

The end of QE is a positive sign for the United States, as it indicates that the Fed has enough confidence in the economic recovery to withdraw the support provided by QE.

Origin of the "Tapering" Discussion

The issue of tapering first moved into the public consciousness when Bernanke, asked about the timing of a potential end to the Fed’s quantitative easing policy in his May 22 testimony, stated, “If we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings ...

take a step down in our pace of purchases.” This was just one of many statements made by Bernanke that day. However, it was the one that received the most attention because it came at a time that investors were already concerned about the potential market impact of a reduction in a policy that has been so favorable for both stocks and bonds.

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 remained in place for the time being, the Fed Chairman also said that the policy was dependent on incoming data. Given the improvement in the U.S. economy, he expected 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.

As a result, the Fed opted to delay the start of tapering until its December, 2013 meeting.

The potential for tapering existed from the beginning of the QE program. 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.

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.

Late in 2013, a widely-held belief was that once the Fed began to pull back on its stimulus, the markets would start to perform more in line with economic fundamentals – which in this case, meant 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. However, the markets subsequently stabilized through the second half of 2013 as investors gradually grew more comfortable with the idea of a reduction in QE.

With the economic recovery gaining traction through 2014 - and investors maintaining a healthy appetite for risk - the process of tapering has had no market impact. In fact, both stocks and bonds performed very well. This indicates that the Fed was correct in its decision to taper its quantitative easing policy, as well as in its timing and approach.