The Fed is increasingly signaling to financial markets that it will withdraw some of the support it provided to the economy during the pandemic. The first step? Slowing down or reducing monthly bond purchases.
Investors expect to find out more next week when Fed Chairman Jay Powell speaks at a Fed conference in Jackson Hole, Wyoming. But how do bond purchases help the economy? And why does the Fed want to withdraw its bond purchases?
Think of the economy like a giant water slide. The Fed pumped water into this chute to keep it going and bought at least $ 120 billion a month in bonds.
“You are flooding the economy with money, so it will be easier for consumers and businesses to get loans with lower interest rates,” said Ann Owen, who teaches economics at Hamilton College.
These firms could use these loans to expand, maybe hire more workers. But the Fed can’t keep the economy going forever. At some point, said economist Claudia Sahm from the Jain Family Institute, consumers and companies will descend this economic water slide all by themselves.
“We’re going to get to the finish line, not with the Fed flooding us all the way because we might overshot and hit the wall at the end of the waterslide,” Sahm said.
In other words, the Fed could overstimulate the economy; but neither can it suddenly stop sending water down the slide.
“If you turned off the water, you’d really burn your butt,” says Ken Kuttner, who teaches economics at Williams College. Investors could get burned if the Fed suddenly turned off its bond-buying spigot, he said.
“You want to be well prepared and prepared for whatever is going to happen, and that’s why Fed officials are starting to make very cautious statements,” he said.
So they are trying to telegraph the gradual reduction in their bond purchases months in advance.