What does it mean for the U.S. Fed to taper?
At the start of the covid-19 crisis almost 18 months ago, the U.S. Fed was amongst the first to act. They acted swiftly and decisively to protect the global financial system and markets. Their primary acts were to drop short term interest rates to 0, and be a ready buyer for all types of securities (US Treasuries, Corporate Bonds, other currencies etc.). They essentially became the entity that was ready to backstop the global economy from a financial crisis.
They were able to do this by the sheer strength of their credibility and their ability to expand and grow their own balance sheet. They were able to buy securities to support the markets and make sure that they were functioning in an orderly manner. We also review the history of how the U.S Fed was founded so check it out if you are a history buff!
So the U.S. Fed spent the last 18 months “buying” assets and putting them on their balance sheet, so it grew. And I mean it GREW!
It doubled from $4.1 TRILLION to over $8.4 TRILLION, and it’s still growing! They are currently buying $120B of assets every month on the open market - $80B of US Treasuries and $40B of US Mortgage Backed Securities.
U.S. Federal Reserve Balance Sheet (Trillions)
source: Federal Reserve Board
So now that the covid-19 crisis seems to be ending (fingers crossed), the U.S. Fed has started mentioning the word “TAPER” in their news conferences and meeting minutes. This means that they will slow down their monthly asset purchases, and eventually end them. This would result in the U.S Fed’s balance sheet growth stopping, and eventually shrinking when securities mature (in a few years).
Financial markets all over the world are waiting with bated breath for the actual “TAPER ANNOUNCEMENT”. The U.S. Fed has been telegraphing that the time is coming sooner rather than later for the last few months. They are being extra careful & over communicating as they try to avoid a replay of the 2013 “Taper Tantrum”. Back then Ben Bernanke’s announcement took the markets by surprise! This caused instability, leading rates to spike higher temporarily, before normalizing. You can read all about it here.
What effect does this have on the real world?
When the world was freaked out due to the covid-19 crisis, the U.S. Fed expanded their balance sheet by buying securities. Now that things are getting back to normal, they are going to reverse course and stop this. The technical effect of this will be lower liquidity in the market, and the stopping of “money printing” by the U.S. Fed.
This is good because it will allow the markets to get back to functioning normally, similar to when painkillers are tapered off and eventually stopped. There may be a rise in the long term interest rates (think mortgages and long term corporate borrowings) in the near term, meaning that investors will be once again “paid” to take risk. Remember, the U.S. Fed did not need to get paid, as they have the ability to “print money”, which us mere mortals lack.
The next step, after the completion of the “Tapering” will be for the U.S. Fed to hopefully raise short term interest rates above 0 where they currently sit. They have said that they will do it very very slowly and only when they believe that the economy is on a very strong footing, as an increase in these rates will affect short term borrowings of businesses which can lead to economic slowdowns.
The upcoming “tapering” and eventual increase in short term rates will come as a welcome relief to savers as they will finally be able to earn some interest on their hard earned money.
In the meantime, the best things we can do are watch the U.S. Fed and the markets very closely, and keep our bond investments to short dated bonds. This way when the rates do rise, we will be able to take advantage at the earliest!
