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.”
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