The Federal Reserve is tapering its aggressive bond-buying program and, if all goes according to plan, may conclude the initiative by the end of the year. The heart of the matter is that the Fed feels the economy has responded sufficiently well to its stimulus following the severe 2007-2009 downturn that it can start turning off the monetary spigot.
The central bank is currently adding $65 billion a month in Treasury bonds and mortgage-backed securities to its balance sheet after reducing its purchasing by $10 billion in each of the past two months. At this point, the Federal Reserve has seven more Federal Open Market Committee (FOMC) meetings scheduled for 2014. Assuming nothing gets in the way, the Fed is on course to wrap up its innovative bond-buying program by the final 2014 FOMC meeting scheduled for December 17th and 18th.
The Fed likes this sort of transparency, and feels it is necessary to keep the financial markets well apprised of its intentions to minimize volatility. The steady approach to the tapering program is reminiscent of the Fed’s last tightening phase in the mid-2000s, when the lead bank raised short-term interest rates through a lengthy series of quarter-point increments. That policy was inaugurated under former Fed Chairman Alan Greenspan and was continued by his successor, Ben Bernanke, the predecessor of current Chair Janet Yellen, who was sworn in on February 3rd.
One point of contention is that the reduction in bond-buying, or tapering, is somewhat akin to the Fed tightening monetary policy, which is only true in a roundabout sense. In fact, the Fed is still taking extremely aggressive stimulus measures to pump up the economy with its zero-interest rate policy and the continuation of bond purchases, even if those purchases are less than they were. Nevertheless, some observers hold that the central bank is, in effect, tightening monetary policy by boosting its balance sheet less aggressively. But the tale of the tape is in the numbers, which show the amount of assets held by the Fed is still expanding although, admittedly, the psychology is beginning to shift.
At most, the tapering initiative is a prelude to the point where the Fed will be able to raise interest rates. Moreover, the lead bank had originally suggested that it would not raise interest rates until the nation’s unemployment rate fell to 6.5%. The latest reading on that measure was 6.6%, and indications are that it may fall further in the coming months, if recent trends persist. That points to 2015 as the earliest the Fed funds rate might start to climb. Even then, short-term rates might not start to move up. Ms. Yellen recently told Congress the central bank’s view of the labor market now places more stress on eliminating the unusually large number of Americans out of work for longer than six months and waiting until more part-time workers looking for a full-time job land positions.
What could go wrong? Basically, the pickup exhibited by the economy in the second half of 2013 needs to largely continue on course. If business conditions were to stall, the Fed would be less inclined to continue tapering its bond-buying initiatives. Meanwhile, recent unsettling developments in certain emerging markets are so far not seen as reason enough to slow or stop the unwinding of the bond-buying program.
Overall, the Federal Reserve seems to be making the right decision to unwind its bond-buying program. While the central bank’s asset purchases have been a plus for the economy, they are probably not sustainable indefinitely without creating side effects, such as asset bubbles or inflation. The reset of policy toward a more neutral stance indicates confidence in the economy, too. Nevertheless, there undoubtedly will be some surprises in the months ahead that may cause the Federal Reserve to consider slowing the pace of tapering.
At the time of this article, the author did not have positions in any of the companies mentioned.