Taper, explained: How the Fed plans to slow its bond purchases without wrecking the economy
The U.S. economy continues to rebound from the coronavirus pandemic, but that doesn’t mean the Federal Reserve’s crisis response is over. Next up comes another important stage, one that’s bound to have an impact on consumers’ wallets for years to come: Weaning the world’s largest economy off of the extraordinary accommodation that came with the COVID-19 crisis.
The Fed’s two most high-profile ways of stimulating an economy during a severe recession — the tools that took center stage during both the virus outbreak and the financial crisis a decade before it — are cutting interest rates and purchasing government-backed debt. Those moves are intended to keep the economy awash with credit and borrowing costs cheap.
Yet, when the financial system is ready, the Fed will eventually start to raise interest rates and gradually decrease how many bonds it’s buying each month, in a policy known as “taper.”
While consumers might be able to easily infer how hiking interest rates affects their finances, taper’s implications can often be much more complex. Here’s everything you need to know about the next stage of the Fed’s crisis response, including what taper is, how it could work and how it could impact you.
What does the Fed mean when it talks about tapering?
Taper refers to a post-crisis asset purchase plan, where the Fed, at a predetermined stated pace, starts to slowly and gradually decrease how many assets it’s buying (the process of purchasing securities for stimulative purposes is commonly called quantitative easing, or Q.E. for short).
In today’s case, the Fed is currently buying $80 billion worth of Treasury securities and $40 billion of mortgage-backed bonds each month, the largest asset purchase program in Fed history that illustrates the severity of the pandemic-induced recession. The Fed purchases those assets on the open market and then adds it to its balance sheet, which has ballooned to more than $8 trillion since the pandemic.
When the Fed ultimately decides that it’s time to taper those purchases, it won’t have been the first time it’s done so. Following the financial crisis of 2008, the Fed in December 2013 began reducing its mortgage-backed and Treasury security purchases by a cumulative $10 billion each month. The process concluded 10 months later, when those purchases hit zero.
“The precedent is that they dialed back their stimulus at a stated pace, and they adhered to that,” says Greg McBride, CFA, Bankrate chief financial analyst. “And unless circumstances would dictate otherwise, expect something similar this time.”
Taper, however, is not to be confused with selling assets and shrinking the balance sheet. Rather, the Fed is simply gradually reducing over a certain period of time how much it’s buying.
“Even if tapering begins, we still have an incredibly accommodative monetary policy,” says Kristina Hooper, chief global market strategist at Invesco. “The Fed is still going to be buying assets, just at a lower rate than it had in the past. There are certainly reasons why the Fed would be motivated to begin tapering this year, even if there are a few hiccups (in the economy).”
How the Fed could taper following the impact of COVID-19
Records of the Fed’s July meeting suggest that officials are still mulling over what taper could look like, including at what pace. One such example could be tapering Treasury securities by $10 billion a month and mortgage-backed bonds by $5 billion, McBride adds, which would give officials an eight-month runway to shrink its purchases down to zero.
“They’ve been buying Treasurys at twice the pace of mortgage-backed securities,” McBride says. “It’s quite possible they taper Treasury purchases at twice the pace of mortgage-bond purchases.”
That, however, is still being discussed, Powell indicated during the Fed’s July press conference. Regardless, Fed officials say they’d taper both mortgage-backed and Treasury security purchases at the same time, Powell added in July.
When the Fed could start to taper
Fed officials in July also admitted that the economy had shown progress, while records of that rate-setting meeting showed that “most” participants could see a bond-buying slowdown beginning at some point this year.
All of that depends on how the economy evolves. The Fed has said that it’d like to see the recovery make “substantial further progress” toward its objectives of stable prices and maximum employment. On the one hand, inflation has soared, with consumer prices in July rising at a pace not seen in 13 years. Meanwhile, the Fed’s favorite gauge of inflation in July soared 4 percent from a year ago.
While inflation has risen, the job market is still being held down by labor shortages and work disruptions as virus cases, enhanced unemployment benefits and child care issues combine to keep workers on the sidelines.
About 3.1 million people have dropped out of the labor force since the start of the pandemic, and up in the air is how many of those exits became permanent. Early retirements and fewer individuals in a household working could’ve been a consequence of the pandemic. Meanwhile, the unemployment rate has steadily declined to 5.4 percent from a high of 14.6 percent, yet the U.S. economy is still short some 5.7 million jobs compared to pre-outbreak levels.
At the same time, Powell seemed confident in July that the economy could quickly recover its lost ground.
“If you look at the number of job openings compared to the number of unemployed, we’re clearly on a path to a very strong labor market with high participation, low unemployment, high employment, wages moving up across the spectrum,” Powell said.
“At what rate could they start, that just depends on the path that the economy takes,” McBride says. “It depends on the path of the economy as well as the threat the virus poses.”
How tapering could impact you
Whatever path the Fed takes, officials will want to give consumers and investors plenty of notice.
That’s because they might have post-traumatic stress from a market sell-off in June 2013, known today as the “taper tantrum.” Then-Fed Chairman Ben Bernanke suggested the economy would soon be strong enough for the Fed to start slowing down its monthly asset purchases, which resulted in a bond and stock market sell off, with equity prices failing and yields soaring.
While experts say the Fed has certainly been more calculated in its communications surrounding taper this time around, consumers might want to brace for volatility, at least in the stock market. Keep a long-term mindset and avoid making any knee-jerk reactions to downdrafts in the market. Better yet, see any market downdraft as a buying opportunity, McBride says.
“The stock market is likely to show heightened volatility amid tapering, but investors are better served focusing on the long run,” McBride says. “And in the long run, if the economy is getting better, so too are corporate profits, and that’s ultimately what drives stock prices. If they (Fed officials) continue to check those boxes, they won’t have to worry about a redo of the taper tantrum — at least in the bond market.”
How the Fed’s eventual taper could impact mortgage rates is also up in the air. Typically, yields would rise once the biggest buyer in the marketplace steps away, which could cause mortgage and refinance rates to also go up. But investors also take into account their expectations for inflation when buying Treasurys.
“The Fed tapering could also be perceived by the market as a more hawkish stance on inflation,” McBride says. “You could actually see long-term yields hover near current lows or move even lower,” McBride said.
Mortgage rates have fallen to historic lows since the start of the pandemic, yet a Bankrate survey from July found that 74 percent of homeowners with a mortgage have not yet refinanced. Would-be refinancers haven’t yet missed their chance, though the refinance window could narrow at a moment’s notice.
“Time is always of the essence because rates can move suddenly, and if they move suddenly, your potential savings can diminish quickly,” McBride says. “I don’t know that the prospect of tapering by itself means people should refinance quickly as much as just the volatile nature of rates. The tremendous savings opportunity that currently exists should get people to refinance as soon as they can.”