Everything you need to know about fed tapering

At the end of August, US Federal Reserve Chair Jerome Powell said that the US central bank would be limiting its bond purchases in a move that economists have expected for months.

What’s fed tapering?

• Federal tapering, or fed tapering, is the process of gradually lessening or reducing something, which can only start after some kind of economic stimulus program has been in effect.

• Often, this economic stimulus is called quantitative easing, or QE, which is when the central bank buys open market items to help keep the economy working and flowing.

• Think of it like this: let’s say a kid opens up a lemonade stand to pay back his mother after breaking her favorite lamp. The kid isn’t getting any business, and the mother isn’t getting a new lamp in the process. So, she decides to put a few dollars in the tip jar at the stand so that other people think people are buying lemonade. While she fully intends on getting her money and her lamp back, she’s hoping to stimulate the lemonade stands profits by putting a little money in herself.

• At some point, though, once the lemonade stand is up and running, she has to stop putting money in because now she’s just losing money and still doesn’t have her lamp.

• In a way, that’s what federal tapering is all about: the government is no longer going to be putting money in the lemonade stand, or, in this case, the government is no longer going to be buying bonds.

What does buying bonds have to do with this?

• At the end of August, United States Federal Reserve Chair Jerome Powell said that the US central bank would be limiting its bond purchases in a move that economists have expected for months.

• The US central bank has been buying US$120 billion worth of bonds since March 18 of this year, as a way to sort of put money in the lemonade stand.

• Buying these bonds increases the market’s liquidity, or cash flow, during unstable times such as the stay-at-home orders that were instituted back in March of last year.

• When people are at home and not working, cash doesn’t flow through the markets as people tend to hold on to money if they aren’t making money.

• So, the US started buying bonds and lots of them. As of August of this year, the US central bank has assets worth US$7.8 trillion.

• The thing is that, much like the mother and the lemonade stand, the US central bank can’t keep stimulating the economy alone. Eventually, it will have to stop putting money into it as the economy stabilizes.

Has fed tapering ever happened before?

• Yes and no.

• “In economics, we always worry about some issues, economic growth, inflation and unemployment rate,” explained Dr. Tenpao Lee, a professor of economics at Niagara University in New York to TMS. “Two-three years ago, we worried about unemployment rate, we worried about economic growth. And, now we worry about inflation because there is a lot of money in the economy.”

• Federal tapering started back in 2013 after the 2008 financial crash, and most of the market reacted negatively to the news because it seemed pretty sudden.

• On May 22 in 2013, Federal Reserve Chair Ben Bernanke gave the first public signal that a taper was on the horizon, triggering what is now commonly known as the “taper tantrum.” But Bernanke didn’t give much more than a single sentence about federal tapering, but the bond-buying program had been in effect for five years at that point and nobody was really prepared for it to change.

• After that one small statement, bond yields rocketed higher, and stock prices dropped and financial conditions over the ensuing months tightened as everyone feared the “dreaded” federal tapering.

• So, in this sense, this version of federal tapering is quite different from the previous. Everyone had a pretty good idea that this was coming, considering the history of tapering and the federal reserve reminding everyone about it over the past few months.

What are the responses?

• Markets have fluctuated since tapering was first hinted at a few months ago, but the impact has not been as severe as the previous federal tapering event.

• Rick Rieder, chief investment officer of global fixed income at BlackRock Inc., seems pretty confident that the Federal government can step away from the market pretty easily without causing any significant harm.

• “With the demand for income and financial assets that we’re seeing …, the modest tapering likely to be seen from the Fed is not consequential for markets,” he said in a note.

• In a segment on CNBC where experts weighed in on the upcoming federal tapering, John Bellows, portfolio manager at Western Asset, is concerned about the economy slowing down in growth as the federal tapering draws near.

• “We’ve seen a material downgrade in U.S. growth. Obviously, there’s a global growth concern emanating from China. It’s not just financial stability concerns, but instead, there’s kind of a broader growth slowdown going on there as well,” says Bellows to CNBC. “And, that’s a big deal for the Fed because a big part of their outlook into 2022 and beyond is kind of robust global growth, and so if you are in a period of slower global growth, I think that has implications for your rate hikes.”

When does fed tapering start?

• The start date for federal tapering has not yet been announced, but it’s important to remember that tapering is a slow process.

• “You have to be careful because if you do it quickly the interest rate will increase, investment will decline so the (gross domestic product) will decline,” explained Lee. “That’s why it’s called ‘tapering.’”

• The last time the federal government began tapering their investments, they removed US$5 billion from their investments every month for 10 months.

• Suddenly stopping their investments into the market would be a horrible move that would destabilize the economy.

• So, the US government will slowly take a few dollars out of the lemonade stand now and then until it operates by itself without the government’s help.

What’s next?

• Lee doesn’t think tapering will be effective.

• “This is from the aggregate demand side. I think right now, inflation is not because of the demand side, the inflation right now is because of the supply side … It’s the broken global supply chain.”

• He added that when “the supply chain is broken, the supply becomes limited so the price increases. So that’s the major reason for inflation right now. So I don’t think tapering is less important than a policy to help rebuild the global supply chain system.”

• For tapering and its impact on equity markets, Lee explained, “Right now if you look at the S&P 500, it’s already dropped 5% from the highest point … And the Nasdaq also dropped 10% yesterday, and recovered a little bit today. But in the immediate future, for example, in one year, because the global supply chain is broken, we will not have economic growth, the unemployment rate will be higher … I’m not saying it will crash, the stock market will decline easily 10%, 15%.”

• Lee explained that the last time tapering occurred, technological advances and productivity increases kept inflation in check. However, under the pandemic, the global economy is shrinking, and productivity has declined, prompting the government to find ways to boost it.

• “It’s a totally different situation … So that’s why the president proposed US$3.5 trillion in infrastructure spending to increase expenditure for infrastructure, specifically, we will also enhance 5G development so we can be more efficient.”

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