An Explanation of Fed Tapering and Its Impact on the Markets

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Tapering in the financial world refers to the winding down of certain activities by a central bank. One program that has seen tapering in recent years is the Federal Reserve's purchase of assets such as those with long-term maturities, including mortgage-backed securities, to help bring down interest rates.

This program, called quantitative easing, was put in place in response to the 2007 financial crisis to get banks comfortable with lending money again. The Fed announced that once it saw a favorable impact on inflation and employment, it would taper its buying program, reducing its purchases each month. 

Fed Tapering in Depth

The “tapering” terminology entered into the financial lexicon on May 22, 2013, when U.S. Federal Reserve Chairman Ben Bernanke stated in testimony before Congress that the Fed may taper, or reduce, the size of its bond-buying program known as quantitative easing (QE). The program, implemented 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 Dec. 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, 2014, with the Fed announcing that the continued improvement in economic conditions warranted a reduction in QE, and the central bank remained on track to have the program wound down before year-end. The Fed opted for this gradual approach to create minimal market disruption.

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 investors were already concerned about the potential market impact of a reduction in a policy that had been so favorable for both stocks and bonds.

For a full, up-to-date explanation of the Fed's maneuvering, read a layperson's explanation of current Federal Reserve policy.

Bernanke followed up his previous statements in the press conference that followed the Fed's meeting on July 19, 2013. 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 would 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 Sept. 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: a string of weaker economic data that had been released in the prior month and 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.

Market Reaction to Tapering

While Bernanke’s tapering statement didn’t represent an immediate shift, it nonetheless frightened the markets. In the recovery that followed the 2008 financial crisis, stocks and bonds both produced outstanding returns despite economic growth that was well below historical norms. The general consensus, which is likely accurate, is that Fed policy was 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 resulted in stocks and bonds that performed very well. This outcome indicated that the Fed was correct in its decision to taper its quantitative easing policy, as well as in its timing and approach.

Ending Quantitative Easing

The U.S. Federal Reserve finished tapering its stimulative quantitative easing policy in 2014. On Dec. 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 tapering concluded, and the program ended following the Fed's October 29–30, 2014, meeting. The end of QE was a positive sign for the United States, as it indicated that the Fed had enough confidence in the economic recovery to withdraw the support provided by QE.

Current Status: Quantitative Tightening

A study assembled by a group of top economists, released in February 2018, concluded that the Fed's balance sheet size has less power over the bond market's movements than many had previously believed, although this thought has been challenged by the market's recent volatility. 

The Fed made a decision in fall 2017 to start shrinking its balance sheet, which had grown due to the buying activity from its quantitative easing program. Instead, quantitative tightening began with the Fed reducing its balance sheet assets by $20 billion each month during Q1 of 2018. The reductions have continued throughout 2018, with a potential reduction of over $300 billion by year-end, and a predicted reduction of over $425 billion in 2019.

To date, the study noted that the Fed's announcement of its balance sheet reductions has caused little more than a "collective shrug" in the market. This reaction is in contrast to what was termed the "taper tantrum" in 2013 as the market had a substantial reaction when the Fed announced it was tapering off its bond-buying activity, and consequently, its efforts to boost the economy.

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 its total bond holdings.

Effects of the Fed's Shrinking Balance Sheet

The Fed's continuing reduction of its balance sheet holdings has started to trigger certain effects in the economy. The Fed plans to continue methodically reducing its balance sheet numbers until they hit more normalized levels, which would result in long-term interest rates slowly rising to a point that resembles historic rates. By doing this, the Fed's policymakers intend, among other things, to free up balance sheet capacity in case of future recessionary needs.

This balance-sheet shrinking—essentially dumping billions of dollars' worth of bond holdings back into the market—could affect investors in three distinct ways:

  1. While the yield on long-term U.S. Treasuries has been rising, so has the cost of a mortgage. If you're planning on buying a home or refinancing, you'll likely see mortgage rates continuing to rise as investors buy fewer bonds and start to worry more about inflation.
  2. The markets have become slightly unsettled, and investors may see more turbulence in the coming months. As shown by the market's volatility during 2018, investors have mixed feelings about the Fed's balance sheet reduction efforts, along with trade wars and fears of rising prices. These conditions add to the market's unpredictability, which is a big change from the consistently bullish market of the recent past.
  3. Investors may also experience lower growth in the economy. The current recovery has broken historical records as the United States' third-longest economic expansion, but the Fed's balance sheet reduction efforts have now introduced a degree of investor uncertainty. Some analysts theorize that, once the expansion ends, the next logical step is a recession, which will likely result in investors moving their funds into more protective financial instruments.