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Taper Explains: How The Fed Will Slow Down Its Bond Purchases Without Wrecking The Economy | news

The U.S. economy continues to recover from the coronavirus pandemic, but that doesn’t mean the Federal Reserve’s crisis response is over. Next up is another important phase that will have an impact on consumer wallets for years to come: Weaning the world’s largest economy away from the extraordinary accommodations that came with the COVID-19 crisis.

The Fed’s two main ways to stimulate an economy during a severe recession – the tools that were at the center of both the virus outbreak and the financial crisis a decade earlier – are cutting interest rates and buying government-backed debt. These steps are designed to inundate the economy with cheap credit and borrowing costs.

However, when the financial system is ready, the Fed will eventually begin to hike rates and gradually reduce the number of bonds it buys each month in a policy known as “taper”.

While consumers can easily infer how rate hikes will affect their finances, the effects of tapering 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 might work, and how it might affect you.

What does the Fed mean when it talks about tapering?

Taper refers to a post-crisis asset purchase plan in which the Fed begins at a predetermined pace to slowly and gradually reduce the number of assets it purchases (the process of buying securities for stimulatory purposes is commonly called called quantitative easing or QE). short).

In today’s case, the Fed is currently buying $ 80 billion worth of government bonds and $ 40 billion worth of mortgage-backed bonds every month. The Fed buys these assets in the open market and then adds them to its balance sheet, which has soared to more than $ 8 trillion since the pandemic.

When the Fed finally decides it is time to cut back on those purchases, it will not be the first time. Following the 2008 financial crisis, in December 2013 the Fed began reducing its purchases of mortgage-backed securities and government bonds by a cumulative $ 10 billion each month. The process ended 10 months later when those purchases hit zero.

“The precedent is that they withdrew their stimulus at a set pace, and they stuck to it,” said Greg McBride, CFA, chief financial analyst at Bankrate. “And unless circumstances dictate otherwise, expect something similar this time.”

However, taper is not to be confused with selling assets and shrinking the balance sheet. Rather, the Fed is simply gradually reducing how much it is buying over a period of time.

“Even if the tapering starts, we will still have an incredibly expansive monetary policy,” says Kristina Hooper, Chief Global Market Strategist at Invesco. “The Fed will continue to buy assets, only at a lower interest rate than in the past. There are certainly reasons the Fed would be motivated to start tightening this year, even if there are a few problems (in the economy). “

How the Fed could rejuvenate after the effects of COVID-19

Records from the July Fed meeting suggest officials are still pondering what the rejuvenation might look like, including the pace. One such example could be cutting government bonds by $ 10 billion a month and mortgage-backed bonds by $ 5 billion, McBride adds, which would give officials an eight-month runway to reduce their purchases to zero.

“They buy government bonds twice as fast as mortgage-backed securities,” says McBride. “It is entirely possible that they will curb government bond purchases twice as fast as mortgage bonds.”

However, this is still being discussed, Powell said at the Fed press conference in July. Regardless, Fed officials say they would be scaling back mortgage-backed and government bond purchases at the same time, Powell added in July.

If the Fed could start tapering off

Fed officials also admitted in July that the economy was showing progress, while the records of that rate-fixing session showed that “most” attendees could see a slowdown in bond buying at some point this year.

It all depends on how the economy is doing. The Fed has said it would like to see the recovery “make significant further headway” towards its goals of stable prices and maximum employment. On the one hand, inflation skyrocketed, with consumer prices rising faster in July than they have been in 13 years. Meanwhile, the Fed’s preferred inflation indicator rose 4 percent year over year in July.

While inflation has risen, the labor market is still held back by labor shortages and work stoppages as virus cases, improved unemployment benefits and childcare issues keep workers on the sidelines.

Approximately 3.1 million people have left working life since the pandemic began, and it is up in the air how many of those exits have become permanent. Early retirement and less-working people in a household could have been a result of the pandemic. In the meantime, the unemployment rate has fallen from 14.6 percent to 5.4 percent, but the US economy is still missing around 5.7 million jobs compared to the level before the outbreak.

At the same time, Powell expressed confidence in July that the economy could quickly regain its lost ground.

“When you look at the number of vacancies versus the number of unemployed, we are clearly on our way to a very strong labor market with high participation, low unemployment, high employment and wages across the board,” said Powell.

“How fast they could start depends only on the path the economy is taking,” says McBride. “It depends on the path of the economy as well as the threat the virus poses.”

How tapering could affect you

Whichever route the Fed takes, officials will want to keep consumers and investors informed in a timely manner.

This is because they may be experiencing post-traumatic stress from a June 2013 sell-off in what is now known as the “Taper Tantrum”. Then-Fed chairman Ben Bernanke suggested that the economy would soon be strong enough for the Fed to slow its monthly stock purchases, causing bond and equity markets to sell off, share prices to fall and yields to skyrocket.

While experts say the Fed was certainly more calculated in its taper communications this time around, consumers should at least be prepared for volatility in the stock market. Maintain a long-term mindset and avoid knee-jerk reactions to downward movements in the market. Better yet, see each market decline as a buying opportunity, says McBride.

“The stock market is likely to have increased volatility during tapering, but investors will be better off if they focus on the long term,” says McBride. “And in the long run, when the economy gets better, so will corporate profits, and that’s ultimately what drives stock prices. If they (Fed officials) keep ticking these boxes, they won’t have to worry about the taper tantrum repeating – at least in the bond market.

How the potential Fed tightening could affect mortgage rates is also up in the air. Typically, once the biggest buyer leaves the market, returns would rise, which could cause mortgage and refinance rates to rise too. When buying Treasuries, however, investors also take their inflation expectations into account.

“The Fed’s tightening could also be perceived by the market as a more restrictive stance on inflation,” says McBride. “You could see long-term yields hovering near current lows or going even lower,” said McBride.

Mortgage rates have fallen to all-time lows since the pandemic began, but a July Bankrate poll found that 74 percent of homeowners with a mortgage have not yet refinanced. Budding refinancers have not yet missed their chance, although the refinancing window could narrow in the short term.

“Time is always of the essence because rates can change suddenly, and if they do suddenly change your potential savings can quickly diminish,” says McBride. “I don’t know that the prospect of tapering alone means people should refinance quickly, like interest rate volatility. The huge savings that exist today should get people to refinance as quickly as possible. “

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