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An Explanation of Fed Tapering and its Impact on the Markets

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The Current Status of Fed Tapering

The Fed is in the midst of tapering its stimulative quantitative easing policy. On December 18, the Fed decided to taper its bond purchases by $10 billion per month, to $75 billion. After three additional reductions, the program currently stands at $45 billion per month. Fed Chairman Janet Yellen expects the program to wind down steadily through 2014 and conclude by year-end, assuming the economy remains healthy.

What is Fed Tapering?

“Tapering” is a term that exploded into the financial lexicon on May 22, when U.S. Federal Reserve Chairman Ben Bernanke stated in testimony before Congress that that Fed may taper - or reduce - the size of the bond-buying program known as quantitative easing (QE). The program, which is designed to stimulate the economy, has served the secondary purpose of supporting financial market performance in recent years.

While Bernanke's surprising pronouncement led to substantial turmoil in the financial markets during the second quarter, the Fed did not officially announce its first reduction in QE until December 18, 2013, at which point it reduced the program to $75 billion per month from its original level of $85 billion. The reason for this move was that the economy had become strong enough for the Fed to feel confident in reducing the level of stimulus. The tapering continued on January 29, with the Fed announcing that the continued improvement in economic conditions warranted a reduction in QE.

Currently, the consensus estimate is that the Fed will continue to reduce the size of its QE program through 2014 and ultimately wind it up by the end of the year. However, this isn't necessarily a guarantee given that 1) the program is data-dependant and 2) both the Fed chairmanship the several board positions will change early next year. As a result, both the timing and extent of the QE withdrawal remains uncertain.

("Data dependant" means that weak growth would lead to a continuation of quantitative easing, improved growth and/or rising inflation would prompt the Fed to continue the program's reduction).

Click here for the 2014 Bond Market Outlook.

Origin of the "Tapering" Discussion

The issue of tapering first moved into the public consciouness when Bernanke, asked about the timing of a potential end to the Fed’s quantitative easing policy in his May 22 testimony, stated, “If we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings ... take a step down in our pace of purchases.” This was just one of many statements made by Bernanke that day. However, it was the one that received the most attention because it came at a time that investors were already concerned about the potential market impact of a reduction in a policy that has been so favorable for both stocks and bonds.

That same day, the minutes of the Federal Open Market Committee – or FOMC, the committee that sets monetary policy – revealed that support for QE is by no means unanimous:

Participants also touched on the conditions under which it might be appropriate to change the pace of asset purchases. Most observed that the outlook for the labor market had shown progress since the program was started in September (2012), but many of these participants indicated that continued progress, more confidence in the outlook, or diminished downside risks would be required before slowing the pace of purchases would become appropriate. A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome.

For a full, up-to-date explanation of Fed policy, see Current Federal Reserve Policy: A Layperson’s Explanation

Bernanke followed up his previous statements in the press conference that followed the Fed's meeting on July 19. While stating that the quantitative easing policy remains in place for now, the Fed Chairman also the policy remains dependant on incoming data. Given the improvement in the U.S. economy, he expects this data-driven approach will prompt him to begin to taper QE before the end of 2013, with the program ending entirely in 2014.

With this as background, the markets expected the tapering to occur at the Fed's September 18, 2013 meeting. However, the central bank surprised the markets by electing to keep QE at $85 billion per month. This shift was likely caused by two factors: 1) a string of weaker economic data that had been released in the prior month and 2) the prospect of slower growth stemming from the oncoming government shutdown and debt ceiling debate.

How Will a Tapering Look?

Tapering isn’t an immediate, dramatic event. Instead, it is likely to take place gradually throughout 2014 so as to create minimal market disruption. Also, it is going to remain dependent on economic conditions. The Fed may pull back slightly if the economy continues to strengthen, but it could also increase the program again if the economy slowed or the financial markets were shocked by an unforeseen crisis.

Tapering Shouldn’t Come as a Surprise

The potential for tapering has existed since QE began. Quantitative easing was never intended to last forever, since each bond purchase expands the Fed’s “balance sheet” by increasing the amount of bonds it owns. Also, in past communications Bernanke had made it clear that the continuation of the program was dependant on incoming economic data.

Bernanke in fact maintained this approach in his May 22 testimony, saying “A premature tightening of monetary policy (i.e., a tapering of quantitative easing) could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further” and “I want to be very clear that a step to reduce the flow of purchases would not be an automatic, mechanistic process of ending the program. Rather, any change in the flow of purchases would depend on the incoming data and our assessment of how the labor market and inflation are evolving.”

Market Reaction to Tapering

While Bernanke’s tapering statement didn’t represent an immediate shift, it nonetheless frightened the markets. In the recovery that has followed the 2008 financial crisis, both stocks and bonds have produced outstanding returns despite economic growth that is well below historical norms. The general consensus, which is likely accurate, is that Fed policy is the reason for this disconnect. Once the Fed begins to pull back on it stimulus, the markets may begin to perform more in line with economic fundamentals – which in this case, means weaker performance. Bonds indeed sold off sharply in the wake of Bernanke's first mention of tapering, while stocks began to exhibit higher volatility than they had previously. The markets subsequently stablized through the second half of 2013 as investors gradually grew more comfortable with the idea of a reduction in QE.

Learn more: What to own - and what to avoid - if bonds enter a bear market.

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