To taper, or not to taper, that is a critical question for the Federal Reserve heading into the final months of the year.

It’s also a conundrum markets are eager to see resolved one way or another, and sooner than later. But what is the Fed tapering, exactly, and why does it seem to drive trading some days in markets? Since you’re bound to see this word often in the weeks ahead, here’s what you need to know about the Federal Reserve and its tapering timeline.

WHAT IS TAPERING?

During times of economic distress, the Federal Reserve can temporarily become a market participant and buy up assets just like an investor (an investor with exponentially more dry powder). This practice is formally known as “quantitative easing” (QE), and it’s a key policy tool the Fed uses to keep interest rates lower during a crisis. Tapering simply refers to the Fed’s intended timeline to reduce, or cease entirely, its asset purchases. People might also say the Fed is “rolling back” its QE program. Both refer to the same thing.

“Keep in mind, the Fed will likely continue to reinvest income and maturities,” says Brent Schutte, chief investment strategist at Northwestern Mutual. “This is an important point. The Fed isn’t shrinking the balance sheet soon.”

WHY DOES THE FED BUY ASSETS?

Since the Great Recession, the Fed has occasionally stepped in and purchased assets, such as long-dated mortgage-backed securities and Treasurys, to put downward pressure on interest rates. When demand for a bond rises, its market value increases, which reduces its coupon rate (i.e., the interest rate). When demand declines, a bond’s market value falls, which increases its coupon rate. Because so many financial instruments, from corporate debt to mortgages, are based on the coupon rate of Treasurys, keeping these rates low by providing a floor for demand provides an appealing environment for companies and individuals to borrow money for growth and consumption.

Here’s how Bill Dudley, former Federal Reserve Bank of New York president, described the net effect of the Fed’s actions in a recent Bloomberg Opinion piece (sub required):

“The private sector may react to the increase in cash and deposit holdings forced on it by the Fed by seeking other riskier higher-yielding assets. In fact, this is a major motivation of quantitative easing. By reducing the supply of safe assets and increasing the amount of deposits that the private sector must hold, the Fed generates a demand by the private sector for more risky assets. The result is a rise in financial-asset valuations and an easing of financial conditions. The Fed’s asset purchases change the mix of assets available to be held by private investors, and this influences asset valuations.”

The Fed restarted this intervention with a massive purchase program in March 2020 in response to the pandemic, and since July 2020 the Fed has purchased $120 billion of Treasury securities and mortgage-backed assets every month. According to FOMC meeting minutes from August, data show the Fed’s monthly purchases have successfully kept longer-term interest rates low and overall financial conditions more accommodative than they otherwise would’ve been.

WHY THE FED IS CONSIDERING TAPERING

The Fed’s primary mandates are to ensure stable prices and maximize employment. If those mandates can be met without asset purchases, the Fed will gladly step back and let markets handle supply and demand independently. The challenge for Fed officials is determining when the economy and markets are up for the task.

We may have short-term effects in some parts of the market, but it’s worth noting that the market has historically climbed during Fed policy tightening cycles.

Currently, the labor market is improving and tilted in workers’ favor. Job openings have outpaced job seekers, and employers are raising wages and incentives to attract new hires and retain current staff. Inflation is elevated, but prices appear to be turning back toward equilibrium as suppliers catch up with demand. Of course, the Delta variant remains a key driver of uncertainty, but the economy overall appears balanced, compelling the Fed to consider tapering its purchases.

WHY DOES THE MARKET CARE?

There are a few reasons the Fed’s tapering timeline can trigger volatility in markets.

First, there’s a risk that markets grow unstable or interest rates rise without the steady influx of Fed purchases. Markets may not function as smoothly, there may be temporary dislocations, and asset prices could eventually alter demand for debt from corporations and consumers. Remember, changes in Treasury coupon rates send ripples through the entire financial system as they are a benchmark for pricing other assets.

Secondly, tapering is seen as a critical step closer to an outright interest rate hike from the Fed. In addition to purchasing assets, the Fed directly sets its Fed Funds Rate, the rate banks charge each other to borrow or lend excess reserves. The Fed lowered this rate to zero in March 2020 as part of its deeper accommodative positioning.

A Fed rate hike could similarly send ripples through markets, particularly through certain segments of the market, such as growth stocks. Risking rates correspondingly reduce the current value of tomorrow’s earnings, which for growth stock are typically further out into the future. Therefore, interest rates can potentially become a headwind to this segment of the market. Still, there are myriad additional factors beyond that prevailing interest rate that will drive a stock’s price higher or lower. In other words, Fed rate hikes are hardly an “all or nothing” deal.

“We may have short-term effects in some parts of the market, but it’s worth noting that the market has historically climbed during Fed policy tightening cycles. It’s only when rates rise too far that markets tend to run into difficulty, but we’re still nowhere near such a high stakes rate hike from the Fed,” says Schutte.

WHAT SHOULD AN INVESTOR DO?

Ultimately, long-term investors needn’t worry about the daily “will they or won’t they” concerns about the Fed.

Over the intermediate term, we think the Fed has fundamentally shifted in its charge. Rather than fight inflation as in the past, the Fed will continue to err on the accommodative side to support markets and employment. The Fed pulled out all the stops during the pandemic, and we see no reason for that to change in future crises.

Over the long haul, however, investing should be a single component of a larger financial plan that aims for growth while managing downside risks and uncertainties. For those engaged in comprehensive planning, Fed policy uncertainty is just one of many risks already accounted for.

Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or try to predict future market performance. To learn more, click here.

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