Tale of the Taper: What Reduced Fed Bond Buying Means for the Economy & Consumer Interest Rates

Effects Fed Tapering

Last May, former Federal Reserve Chairman Ben Bernanke told Congress that the Fed might, in the future, begin to reduce its massive bond purchases under its Quantitative Easing (QE) program. Almost immediately, the financial markets became obsessed with when this “taper” of bond purchases, which was seen as holding down interest rates, would happen.

It finally happened in December when the Fed announced it would reduce its monthly bond purchases from $85 billion to $75 billion beginning in January 2014. But by then the financial markets had almost no reaction. The stock market hit a series of record highs during the month of December and has been erratic thus far through 2014.

But the experts we consulted say the action will have some effect over time, especially on interest rates.

Effect on Interest Rates

“Such an action has expectation effect which means that the mortgage rates will go up,” said Amir Kia, professor of economics at Utah Valley University. “However, I have doubt that the short-term rates go up immediately.”

Indeed, bond rates made no sudden move in the wake of the Fed’s decision, but by the end of 2013 the yield on the 10-year Treasury note had risen above the 3% mark.

Michael Ellis, an economics professor at Kent State University, agrees that there shouldn’t be a sudden move in interest rates. He points out the tapering announcement was accompanied by a statement implying that the Fed’s policy of targeting the federal funds rate near zero will persist for a longer time, perhaps into 2015.

“This should help keep interest rates from rising much, even as Fed bond buying is tapered,” he said. “Also, inflation expectations have remained stable for the last few years and I expect that to continue as long as the economy continues to improve gradually, so the inflation premium component of interest rates will likely not change much.”

Good News for Stocks?

What does the taper mean for the stock market? In the immediate aftermath, traders seemed to view the move as good news as they pushed stock indices ever higher.  Lloyd Thomas, professor of monetary economics at Kansas State University, says the reaction is understandable since the Fed action was, in fact, good news.

“Introduction of tapering essentially means that the consensus within the Fed is that, with three straight months of job creation exceeding 200,000 per month, and with signs that Europe may have turned the corner favorably, and with signs that the obstructionists in Congress may be modifying their behavior, and the size of the sequester may be reduced, the potential costs of continuation of QE of $85 billion per month exceed the potential benefits,” Thomas said.

In other words, the economy is growing strong enough to stand on its own two feet and widespread bond buying, at least to the tune of $85 billion a month, is no longer necessary.  And a healthier economy means a more robust stock market, right?

Russ Ray, professor of finance at the University of Louisville, believes 2014 will be marked by “slow but steady growth due to solid fundamentals in the economy, but a nervous market until uncertainty about QE2 is flushed out, causing volatility in the market.”  Ray expects tapering to cause “an exodus from bonds and into the stocks, thus … pushing stocks upward.” The only question, he says, is how quickly Janet Yellen, Ben Bernanke’s successor as Fed Chairman will wind down the quantitative easing program? “Until this is settled, stocks will be upward but volatile.”

And if it turns out the Fed began tapering too soon? In that case, Thomas says he has no doubt that Bernanke’s replacement as Fed Chairman, Janet Yellen, will have little difficulty persuading her Fed colleagues to re-institute an aggressive QE program.

The Road Ahead

While no such announcement has yet been made, the general consensus seems to be that the Federal Open Market Committee will reduce its monthly bond purchases by $10 billion at each of its eight meetings in 2014.  This, of course, will depend on how the markets react in the interim.  Either way, consumers shouldn’t have to worry about paying much higher interest rates this year.

“At some point, [the Fed] will eventually decide to raise short-term interest rates, but possibly not until late in 2015,” Katheryn N. Russ, associate professor of economics at the University of California, Davis said. “As an indication of how markets view that information, the Fed’s announcement had little, if any impact on interest rates.”

Meet Our Experts

 

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Eric Fisher

Professor, California Polytechnic State University, Orfalea College of Business

Now that the Fed has announced the general parameters for tapering its bond buying program, what will happen to interest rates?

Interest rates will rise for two reasons. First, the Fed will be buying fewer bonds, so their prices will drop and their yields will rise. Second, there is a long history of loose monetary policy that will give rise to higher expected inflation. Then nominal interest rates will rise because of the Fisher effect.

What about the stock market? Were previous negative reactions to rumors of a taper more indicative of general uncertainty than the actual implications of the policy?

There will be only a transitory effect on the stock market. A stock is worth the present of its future stream of dividends. These do not depend upon nominal interest rates.

What does the introduction of tapering say about the state of the economy? What will happen if it turns out the Fed jumped the gun?

It says more about the past than about the future. The Fed has had loose monetary policy for so long because commercial banks have held excess reserves since the fall of 2008. It’s a no-brainer that sooner or later the Fed would have to stop having such an expansionary policy.
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Douglas Pearce

North Carolina State University

Now that the Fed has announced the general parameters for tapering its bond buying program, what will happen to interest rates?

I would think that long term rates will rise given the smaller infusion of liquidity and the uncertainty of how fast the tapering will actually be done. To the extent that the market thinks that the Fed’s prediction for the economy is more accurate than private forecasters – and there is some evidence of this – the stronger economy should increase investment spending and credit demand. Of course if the banks are more confident and reduce their excess reserves by increasing lending this would reduce the upward pressure on interest rates, assuming it did not trigger increases in expected inflation.

What about the stock market? Were previous negative reactions to rumors of a taper more indicative of general uncertainty than the actual implications of the policy?

If expected profits did not rise, then increases in interest rates should reduce the present value of future profits and hence reduce stock prices. Given the market’s positive response, the market must think the stronger economy will raise profits and this effect will more than offset the increase in interest rates.

What does the introduction of tapering say about the state of the economy? What will happen if it turns out the Fed jumped the gun?

The Fed must think the economy is improving and recent GDP numbers will reinforce this. We are unlikely to know if the Fed moved too soon for several quarters.
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Amir Kia

Utah Valley University

Now that the Fed has announced the general parameters for tapering its bond buying program, what will happen to interest rates?

The signal effect of the central bank, in this case, has impact on the long term rate than short term rates. The reason is that the Fed said that it tapers its bond buying not it will reverse its action.

What about the stock market?

In my opinion stock markets have already incorporated the Fed announcement. Based on my studying both stock and money markets in the US are efficient. Of course, we should ignore the noise traders’ reactions to the announcement. Unfortunately, there is bubble in the stock price in the US, and so stock price, everything else being constant, may fall as a result of the announcement. But, there are other determinants for the stock price which could offset the fall in the stock price.

Were previous negative reactions to rumors of a taper more indicative of general uncertainty than the actual implications of the policy?

No, it is because of market efficiency at least in the semi-strong form.

What does the introduction of tapering say about the state of the economy?

It says that according to the Fed the improvement in the economy is not superficial, but it is fundamental. Therefore, there will be a possibility of inflation over the short-run, but not over the long term.

What will happen if it turns out the Fed jumped the gun?

Markets in the US are efficient and so market participants would have seen this.
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Michael Ellis

Kent State University

Now that the Fed has announced the general parameters for tapering its bond buying program, what will happen to interest rates?

I don’t expect much effect on interest rates for a couple of reasons. First, the announcement of tapering the bond buying program was accompanied by a statement implying that the Fed’s policy of targeting the federal funds rate near zero will persist for a longer time, perhaps into 2015. This should help keep interest rates from rising much, even as Fed bond buying is tapered. Also, inflation expectations have remained stable for the last few years and I expect that to continue as long as the economy continues to improve gradually, so the inflation premium component of interest rates will likely not change much.

What about the stock market? Were previous negative reactions to rumors of a taper more indicative of general uncertainty than the actual implications of the policy?

I think the stock market will not react negatively as it did to rumors of a taper earlier in 2013. While tapering will reduce the support of the stock market, there are a couple of factors that will mitigate this negative effect on the market. First, investors looking forward expect the economy will do better in the coming year than in 2013. Not only has the economy continued to improve, but the recent budget deal in Congress suggests that fiscal policy will be less of a drag on the economy in the coming year. Second, I think part of the previous negative reaction to rumors of tapering was indicative of general uncertainty and the Fed’s decision this week should reduce uncertainty and be a positive for the stock market. The Fed has made it clear the magnitude of the taper will be small, which might not have been as clear earlier in 2013. I also think the market might not have understood clearly that the taper would not change the policy of maintaining the federal funds rate target near zero for a long time, and this point has been made clearer by the Fed.

What does the introduction of tapering say about the state of the economy? What will happen if it turns out the Fed jumped the gun?

The introduction of tapering suggests that the Fed believes the gradual improvement in the economy will be sustained. If it turns out the Fed has tapered prematurely it would present a dilemma. On the one hand, the primary way to provide support to the economy when the federal funds rate target is already near zero is to reverse the tapering of bond purchases to push long term interest rates downward. On the other hand, reversing the tapering of bond purchases would increase uncertainty in financial markets, which the Fed would want to avoid. I believe the Fed would reverse the tapering and increase the pace of bond purchases only if the deterioration of the economy was substantial. Otherwise, they would likely maintain the pace of bond purchases.
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Katheryn N. Russ

University of California, Davis

Now that the Fed has announced the general parameters for tapering its bond buying program, what will happen to interest rates?

In general, when the Fed reduces the money supply, we expect interest rates to increase. This situation may fall within that category. However, the economy has been at what is called a zero lower bound, where the economy (especially investment) was not very responsive to short-term interest rates, even after the Fed lowered them to zero. So the Fed began what is called quantitative easing. In particular, since it could not lower short-term interest rates further, it began injecting cash into the economy by buying up securities. The taper will not immediately reduce the money supply, initially it will just slow very slightly the continued expansion of the money supply, at a time when short-term interest rates have been at zero for an extended period of time. The Fed explicitly said that it will slow its purchases of mortgage-backed securities, but at the same time will use other means to keep short-term interest rates at zero.

Ordinarily, if the Fed tightened its stance, I would expect an immediate increase in short-term interest rates. In my personal opinion, in this case it seems that the Fed is planning the taper because it wants to make sure it does not have so many assets accumulating on its balance sheet, since the way it releases cash into the economy is to purchase assets. This is not the same thing as when the Fed announces an increase in the Fed Funds rate to dampen an overheating economy, for instance. The Fed announced that it will actually continue its quantitative easing in the near term, just at a slower rate. At some point, it will eventually decide to raise short-term interest rates, but possibly not until late in 2015. As an indication of how markets view that information, the Fed’s announcement on Wednesday had little if any impact on interest rates.

What about the stock market? Were previous negative reactions to rumors of a taper more indicative of general uncertainty than the actual implications of the policy?

Things are different now than when the taper was last rumored. First and foremost, there appears to be a budget agreement in the House and Senate that will raise federal spending over the next two years. Just months ago, the economy was operating under nontrivial cuts in federal spending (the sequester), the threat of and then an actual shutdown, and a threat of voluntary sovereign default with no signal as to when a more typical federal budget situation would return. All of those things previously made investors very jumpy at the idea of a taper, since the Fed’s monetary stimulus seemed to be the principal support for economic recovery during those turbulent times.

Now we have two years of breathing room. This is good news for stock prices and the Fed’s recent announcements seem to be very measured and transparent, delivered with an eye toward longer term planning to strengthen rather than undermine that confidence. Stock prices rose after the Fed’s announcement on Wednesday.

What does the introduction of tapering say about the state of the economy? What will happen if it turns out the Fed jumped the gun?

The Fed is not jumping the gun, since the latest indications are that they will maintain a very low interest rate policy for at least the next year. In my personal opinion, I think that the taper—the slowing of the Fed’s purchases of mortgage-backed securities (with no immediate plans to increase short-term interest rates)—indicates an interest in slimming down the Fed’s balance sheet and possibly an increased confidence in the functioning and liquidity of the this derivatives market, possibly an improved outlook regarding the health of bank balance sheets. The fact that the Fed has indicated that it plans to keep interest rates low for at least the next year informs us that the economy is still fragile and the recovery incomplete. And it is. Among other things, we see that jobless claims are still high, unemployment is elevated, municipal and state budgets are strained in many places. The Fed is not abandoning anyone halfway through the recovery.
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Warren Smith

Palm Beach State College

Now that the Fed has announced the general parameters for tapering its bond buying program, what will happen to interest rates?

I think for the short run, rates will continue relatively low. But if we continue to see stronger growth in the economy particularly job growth rates may edge up slightly.

What about the stock market? Were previous negative reactions to rumors of a taper more indicative of general uncertainty than the actual implications of the policy?

The market will respond positively because the Fed has removed some uncertainty within the economy.

What does the introduction of tapering say about the state of the economy? What will happen if it turns out the Fed jumped the gun?

I think the Fed wants to wean us off its dependency somewhat, but not entirely just yet! This is why tapering will move slowly over the next year or so. I think the Fed knows what aggressive tapering could cause in the short run.
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Josh Hendrickson

University of Mississippi

Now that the Fed has announced the general parameters for tapering its bond buying program, what will happen to interest rates?

I don’t anticipate that much will change with regards to interest rates in the near term. Longer term, interest rates should begin to rise and the yield curve should steepen if the economy continues to grow at this pace.

What about the stock market? Were previous negative reactions to rumors of a taper more indicative of general uncertainty than the actual implications of the policy?

I think that the taper signals to markets that the Fed is serious about beginning to rein in its asset purchases and that the tapering will be gradual. As a result, I would anticipate that the taper should be priced into stocks going forward, unless there is a radical change in policy. The previous reactions to rumors of the taper were primarily driven by uncertainty. Prior to announcing how the tapering of asset purchases would proceed, it was unclear the degree to which monthly asset purchases would decline. Going forward, I think the market has a better understanding of what to expect from the Federal Reserve.

What does the introduction of tapering say about the state of the economy? What will happen if it turns out the Fed jumped the gun?

The Federal Reserve is slowing the rate of money growth with the taper. Thus, the Fed is essentially signaling that the economy is much closer to their targets for inflation and unemployment and that this lower level of money growth is commensurate with these targets. If it turns out that the Fed started the taper too soon (through evidence in asset markets, unemployment, and/or inflation), the Fed would at the very least alter their tapering timetable and likely reverse course with asset purchases. I don’t see any recent evidence to suggest either scenario will be needed, however.
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Lloyd Thomas

Kansas State University

Now that the Fed has announced the general parameters for tapering its bond buying program, what will happen to interest rates?

Of course, short-term interest rates will be unaffected by the Fed Taper. The Fed will keep the federal funds rate in the 0 – 0.25 percent range for at least a year. Longer-term interest rates are influenced by a variety of factors, including inflation expectations, the strength of the economy, and safe-haven considerations. Inflation and inflation expectations remain quite low, and the economy is weak, but slowly picking up strength. These two factors auger against a sharp increase in bond yields in the next year. I would not anticipate a sharp increase in long-term bond yields in the next 6 months to a year—the 10-year Treasury bond yield might increase by 20-50 basis points in the next year as inflation picks up a bit and the economy strengthens.

What about the stock market? Were previous negative reactions to rumors of a taper more indicative of general uncertainty than the actual implications of the policy?

Previous reactions to Fed announcements were totally irrational. Whenever the Fed hinted it may terminate QE, the market would sell off. It should have risen on such announcements as the announcements indicated the Fed thought the economy could make it on its own—-without assistance of QE. The market finally got it right this week, when it rallied on news that the Fed would begin tapering.

What does the introduction of tapering say about the state of the economy? What will happen if it turns out the Fed jumped the gun?

Introduction of tapering essentially means that the consensus within the Fed is that, with three straight months of job creation exceeding 200,000 per month, and with signs that Europe may have turned the corner favorably, and with signs that the obstructionists in Congress may be modifying their behavior, and the size of the sequester may be reduced, the potential costs of continuation of QE of $85 billion per month exceed the potential benefits. If it turns out that the Fed jumped the gun, I suspect that Janet Yellen will persuade her colleagues on the FOMC to re-institute an aggressive QE program.
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Doris Geide-Stevenson

Weber State University

Now that the Fed has announced the general parameters for tapering its bond buying program, what will happen to interest rates?

Given the Fed’s assurance to keep the federal funds rate virtually at 0% should guarantee that short-term interest rates will remain low. Given the size of the taper, $10 billion increments per FOMC meeting in the near future is unlikely to affect long-term rates as well. It is instructive to consider the average daily trading volume of the 10-yr Treasury bond market. This volume is about $530 billion daily. The size of the taper should not affect rates as long as market expectations do not change significantly.

What about the stock market? Were previous negative reactions to rumors of a taper more indicative of general uncertainty than the actual implications of the policy?

As I don’t anticipate changes in the interest rate, I do not anticipate any big changes in the stock market from the taper.

What does the introduction of tapering say about the state of the economy? What will happen if it turns out the Fed jumped the gun?

The state of the economy has been improving slowly, but steadily and the introduction of tapering at this point in time does not indicate any large changes with regard to the underlying economic fundamentals. Starting tapering at this point in time should help to increase the flexibility of the incoming chair of the Board of the Federal Reserve. If the economy starts to show signs of weaker growth, reducing or ending tapering is now an option for the new chair. This may be more easily defended than a new round of QE.
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Russ Ray

University of Louisville

What is the outlook for the stock market in 2014? Will low interest rates continue to push investors away from bonds?

STOCK MARKET IN 2014: Slow but steady growth due to solid fundamentals in the economy, but a nervous market until uncertainty about QE2 is flushed out, causing volatility in the market. Yes, undoubtedly Janice Yellen will cut back on QE2, causing an exodus from bonds and into the stocks, thus another factor pushing stocks upward. The only question is, how quickly will she wind down QE2? Until this is settled, stocks will be upward but volatile.

 
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