As a new year approaches, the Federal Reserve announced it will start tapering its bond purchases. The Fed has used the unconventional strategy in an attempt to stimulate economic activity in the wake of the Great Recession.
Through the program, the Fed has purchased about $4 trillion in Treasury obligations and mortgage-backed securities, currently at the rate of $85 billion per month, in three rounds of “quantitative easing.” The initial reduction of $10 billion will take place in January 2014.
Why did the Fed decide to begin the taper? What will be the impact on the financial markets?
To answer the questions, one should understand the Fed’s motives, criticized by many observers, for the purchases. Critics believe the large-scale printing of money will lead to inflation as the economy fully recovers.
Because other approaches had failed, the Fed used the unprecedented measure as a last resort. The intent was to provide liquidity to the financial system to stimulate the economy and lower long-term interest rates. Through this action, both long- and short-term rates have been at all-time lows.
At this point, the only announced reduction will take place in January. But others could occur as the policy-setting Federal Open Market Committee (FOMC) meets during the year. The FOMC, comprising the seven Fed governors and five district bank presidents, is scheduled to meet eight times in 2014. If it should decide to reduce purchases by $10 billion at each meeting, the program would terminate by the end of 2014.
The immediate impact on the financial markets was significant. As the decision was announced, the Dow-Jones Industrial Average surged to an all-time high.
The markets inferred from the Fed’s action that the economy is finally experiencing some growth. And this is borne out by the jump of 4.1 percent in gross domestic product for the third quarter of 2013 and significantly lower unemployment in November.
In the long run, much will depend upon the Fed’s actions during the year. If the purchases continue to taper off, long-term interest rates could rise if anxiety about inflation affects investors.
Short-term rates will not increase until the economy is strong enough – and unemployment low enough – for the Fed to hike the federal funds rate.
Wayne Curtis, Ph.D., is a former superintendent of Alabama banks and Troy University business school dean. He is retired from the board of directors of First United Security Bank. Email him at wccurtis39@gmail.com.
