4 Answers to Questions About the Taper Everyone Should Know

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After much waiting and fanfare, the Federal Open Market Committee of the U.S. Federal Reserve announced on December 18 that tapering would begin. The committee decided to reduce its purchases of agency mortgage-backed securities from $40 billion per month to $35 billion per month and reduce its purchases of longer-term Treasuries from $45 billion per month to $40 billion per month.

The taper was not severe, and Fed Chair Ben Bernanke used his last press conference as head of the central bank to ease the markets into the transition. Equities rallied in the days following the announcement, and the yield on the benchmark 10-year Treasury note increased just slightly, about 5 basis points. Economists polled by Bloomberg expect the Fed to reduce the rate in measured increments over the next seven FOMC meetings, ending the program by December 2014.

There’s a lot to unpack about the decision, so let’s get started.

1. Why is it such a big deal?

There’s no point pretending that the U.S. Federal Reserve’s response to the financial crisis and the Great Recession was straightforward — it was not. It was unprecedented, rushed, enormously complex, and highly controversial. Bernanke enacted the monetary equivalent of martial law in 2008, ignoring previously accepted conventions and exercising the extraordinary power of the Fed as monetary steward and financial regulator to facilitate the bailout of and to restore liquidity to the financial sector.

The Fed was not the only emergency responder during the financial crisis — Congress authorized the Treasury to conduct the single largest bailout of the financial sector in 2008 with the Emergency Economic Stabilization Act — but in the wake of the recession, flanked by contractionary fiscal policy, it has become the principal economic executive. True to its roots as a banker’s bank, a lender of last resort, and a financial stabilizer, the Fed has assumed responsibility for nursing the U.S. economy back to health after it suffered the worst financial crisis since the Great Depression.

It’s not a perfect analogy, but the Fed has basically become the economy’s primary physician, and tapering QE is like beginning to take someone off medication following surgery. We may not be totally healed, but at a certain point it’s not worth being hooked up to the IV anymore.

2. Why is now the right time?

The decision was made, according to the Fed, “In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions.” Headline unemployment fell from 7.3 percent to 7 percent in November, and a projection released by the FOMC puts the headline rate at between 6.3 percent 6.6 percent in 2014, more optimistic than the September projection. Through November, the economy added an average of about 195,000 jobs per month over the past three months and an average of 181,000 jobs per month in the past six months.

The labor market, though, is really just a window into the broader economy. “Taking into account the extent of federal fiscal retrenchment since the inception of its current asset purchase program, the Committee sees the improvement in economic activity and labor market conditions over that period as consistent with growing underlying strength in the broader economy,” the FOMC said when it announced the taper.

Inflation is still a bit of a wild card. The Fed has consistently overestimated inflation in the post-crisis period, with the actual rate falling well below the central bank’s projections. The FOMC targeted an inflation rate of 2 percent, but headline inflation is as low as 1.2 percent, while core inflation has run at about 1.8 percent. The Fed appears willing to tolerate soft inflation on the expectation that it will return toward its longer-run objective.

3. Why did stocks markets rally?

It’s no secret that financial markets have become addicted to QE. The Fed’s asset purchases have helped boost equity valuations over the past few years, and with its usual, awkward prescience, the markets priced in the anticipated policy shift over the past few months. The market threw two taper tantrums earlier this year when Bernanke suggested that the taper may come sooner than expected.

Taper talk really started heating up in May. From the beginning of that month through the middle of September, equities pretty much mimed the outline of a roller coaster. The S&P 500 ended the period between May 1 and September 17 up about 7.7 percent, but not without experiencing the deep ups and downs attributable to uncertainty and a changing environment. At the same time, interest rates climbed nearly a full percentage point, as indicated by the yield on the 10-year Treasury note.

Far from throwing a tantrum, though, equities rallied when the FOMC announced the taper. The reason for that was the Fed’s good timing, with Bernanke able to leverage his last press conference as Fed chair to help ease the transition. Bernanke made it clear that the Fed was committed to supporting the economy (through the financial markets) for as long as it takes, while simultaneously signaling that the bank believes underlying economic conditions are improving. The taper had to happen, and Bernanke made it as digestible as possible.

4. What will happen to interest rates?

There is one tool that the Fed has historically reached for when it needed to nurse the economy back to health. That tool is the raising or lowering of the target federal funds rate, which, ostensibly, creates an accommodative monetary environment that facilitates healing.

The federal funds rate is the interest rate at which banks — that is, depository institutions — trade balances held at the Fed. This rate serves as a benchmark for other interest rates throughout the financial market. When it is lowered, interest rates in general tend to decrease as well; when it is raised, interest rates tend to increase. Low interest rates help stimulate economic activity by encouraging borrowing and spending: Businesses can more easily access credit to buy capital or expand payrolls, and consumers can access cheaper loans for automobiles or home purchases. Higher interest rates tend to have the opposite effect.

In 2008, as the financial crisis wreaked havoc on the banking system and credit markets began to seize, the Fed slashed the target federal funds rate to the zero bound — the first prescription the Fed wrote – and it has remained there ever since. This has helped keep interest rates low, which has helped stimulate economic activity when it was most needed.

Quantitative easing was the second prescription. QE, as it’s called, is designed to spur economic activity by reducing long-term interest rates, which will stimulate spending in areas like the housing market. As Fed Vice Chair Janet Yellen articulated in her recent testimony before the Senate Banking Committee, QE should “stimulate a favorable dynamic in which jobs are created, incomes rise, more spending takes place.”

QE can come in many shapes and sizes. The first QE programs instituted in response to the crisis in the U.S. were purchases of a fixed amount of Treasuries spread out over a fixed amount of time. The current iteration of QE is open ended and uses a flow rate of purchases instead of a fixed total. In effect, this is the difference between a prescription that can’t be refilled and one with unlimited refills.

That is, unlimited refills until the doctor says enough. As QE purchases are tapered, longer-term interest rates such as those on the 10-year Treasury note and on mortgages are expected to rise as Fed-induced demand is removed from the market. Shorter-term interest rates, which are linked more closely to the target federal funds rate, are expected to remain trapped near the zero bound.