Here’s what will happen when the Fed’s ‘tapering’ starts, and why you should care

Likely before the end of the year, the Federal Reserve will start to tiptoe into the unknown.

Central bank officials indicated Wednesday that they’re ready to begin “tapering” – the process of slowly pulling back the stimulus they’ve provided during the pandemic.

While the Fed has gone into policy retreat before, it has never had to pull back from such a dramatically accommodative position. For most of the past year and a half, it has been buying at least $120 billion of bonds each month, providing unprecedented support to financial markets and the economy that it now will start to walk back.

The bond purchases have added more than $4 trillion to the Fed’s balance sheet, which now stands at $8.5 trillion, about $7 trillion of which is the assets bought up through the Fed’s quantitative easing programs, according to the central bank’s data. The purchases have helped keep interest rates low, provided support to markets that malfunctioned badly at the start of the pandemic crisis, and coincided with a powerful run for the stock market.

In light of the role the program has played, Fed Chairman Jerome Powell assured the public Wednesday that “policy will remain accommodative until we have reached” the central bank’s goals on employment and inflation.

Markets thus far have taken the news well, but the real test is ahead. Tapering represents a teeing up of future rate hikes, though they appear to be at least a year in the distance.

“It’s certainly been communicated well, so I don’t think that should be a shock to anybody or cause a disruption to the market,” said Kathy Jones, head of fixed income at Charles Schwab. “The question really is more around asset prices than [interest] rates. We have very high valuations across the board in asset prices. What does this shift away from very easy money do to asset prices?”

The answer so far has been … nothing. The market rallied Wednesday afternoon despite what amounted to a preannouncement for Fed tapering, and roared higher again Thursday.

How things go the rest of the way likely depends on how the Fed stage manages its exit from its money-printing operations.

Here’s what tapering could look like:

Powell said the official tapering decision could happen at the November meeting and the process would commence shortly thereafter. He added that he sees tapering being finished “sometime around the middle of next year.” That timeline, then, offers a view into how the actual reductions will go down.

If the taper indeed begins in December, reducing the purchases by $15 billion a month would get the process down to zero in eight months, or July.

Jones said she would expect the Fed to cut Treasurys by $10 billion a month and mortgage-backed securities by $5 billion. There have been some calls from within the Fed to be more aggressive with mortgages considering the inflated state of housing prices, but that seems unlikely.

Powell’s general tone during this post-meeting news conference surprised Jones. The chairman repeatedly said he is satisfied with the progress made toward full employment and price stability. With inflation running well above the Fed’s comfort zone, Powell said “that part of the test is achieved, in my view, and in the view of many others.”

“The tone was perhaps a little bit more hawkish than the market expected when it comes to tapering,” Schwab’s Jones said. “That comment that the Fed will finish by the middle of next year, it was like, ‘OK, we had better get a move on here if we’re going to do that.'”

Jones said that Powell’s comments and the Fed’s tapering intentions reflected a high level of confidence that the economy continues to recover from the pandemic-induced recession, which was both the shortest and steepest in U.S. history.

“The Fed is telling us that it collectively expects growth and inflation to be pretty strong over the next year, and they’re ready to withdraw the easy policy,” she added.

What happens after the taper is what’s really important.

The summary of individual members’ rate forecasts – the vaunted “dot plot” – indicated a slightly more aggressive posture. The 18 members of the policymaking Federal Open Market Committee are about split on whether to enact the first quarter-point hike next year.

Officials see as many as three more hikes in 2023 and in 2024, bringing the Fed’s benchmark borrowing rate to a range between 1.75% and 2%, from its current 0 to 0.25%. Powell stressed the Fed will move carefully before raising rates and likely will wait until tapering is complete, but the market will be watching for more hawkish indications.

“The next Fed meeting could be really interesting. It should give us a lot more volatility than we’re seeing now,” said John Farawell, head trader with bond underwriter Roosevelt & Cross. “They did sound more hawkish. It’s going to be data-driven and going to be about how Covid plays out.”

For investors, it will be a new world in which the Fed is still providing support but not as much as before. While the mechanics sound simple things could get complicated if inflation continues to run above the Fed’s expectations.

FOMC members upped their 2021 core inflation estimate to 3.7%, increasing it from the 3% projection in June. But there’s plenty of reason to believe that there’s considerable upside to that forecast.

For instance, in recent days economic bellwether companies including General Mills and Federal Express have indicated that prices are likely to rise. Natural gas is up more than 80% this year and will mean substantially higher energy costs heading into the winter months.

UBS forecasts that economic conditions and the tapering news will start putting upward pressure on yields, driving the benchmark 10-year Treasury to 1.8% by the end of 2021. That’s about 40 basis points from its current level but “should not have a significant adverse effect on borrowing costs for companies or individuals,” UBS said in a note for clients.

Yields move opposite prices, meaning that investors will be selling bonds in anticipation of higher rates and less Fed support.

Analysts at UBS say investors should keep in mind that the Fed is moving forward because it is getting more confident in the economy, and still will be providing support.

“While higher bond yields lower the relative attractiveness of equities, a gradual rise in bond yields should be more than offset by the positive impact from rising earnings as economies return to normal,” the firm said. “Tapering should thus be seen as the gradual withdrawal of an emergency support measure as conditions normalize.”