Will the Fed taper?
That is the question that will be resolved Wednesday afternoon with the Federal Reserve’s monetary policy announcement and press conference with Chairman Ben Bernanke.
But as a recent Reuters poll found, most of the public do not know what the taper is about, or understand what the Fed has been doing.
The taper would be the beginning of the end of the unusual and extraordinary stimulus measures the Fed has used over the past five years to counteract the recession.
In normal times, the Fed uses just one tool to implement monetary policy: the manipulation of short-term interest rates. It raises rates to tighten money, and lowers them to loosen.
But during the free-fall of the financial crisis, the Fed pushed short-term interest rates all the way to zero. It couldn’t lower them any more, but the economy continued to contract, and job losses continued to mount.
To continue easing monetary conditions in late 2008 and early 2009, the Fed created a number of new programs to purchase troubled bank and other financial firm debts, financed by creating new bank reserves at the Fed — in other words, printing money. This round of asset purchases or ‘quantitative easing’ is now known as QE1, although it was not called that at the time.
In November 2010, with the recession officially over but no strong recovery in sight, the Fed engaged in another round of QE to boost the economy. This time, it announced it would buy $600 billion of Treasury bonds over the course of the following eight months, again expanding its balance sheet.
The $600 billion in new purchases of securities, referred to as QE2, represented a radical departure from the Fed’s usual ways of doing business and a new front in fighting the effects of the recession.
By the time the bond purchases were finished in mid-2011, the Fed’s balance sheet had expanded enormously to accommodate QE1 and QE2, as shown in this chart from the Fed’s Board of Governors:
Meanwhile, the Fed had started using another tool to loosen monetary conditions, namely promises to keep rates near zero.
It first made use of this tool, called “forward guidance,” when it lowered rates to zero in December 2008, saying in its announcement that the weak economy was “likely to warrant exceptionally low” short-term interest rates “for some time.”
Over the following months, Bernanke and company added some detail to its forward guidance.
In March 2009, with job losses mounting, the Fed changed the wording of the forward guidance, saying that rates would be zero “for an extended period.” And in August 2011, it specified a date: rates would be zero “at least through mid-2013,” and in following months pushed that date back, until in September 2012 it promised to keep rates low at least through mid-2015.
But despite the combination of QE and forward guidance, at the end of 2012, it appeared that the already tepid recovery might falter, as this chart of gross domestic product growth shows:
And so in December 2012 the Fed tried a new tactic: an open-ended commitment to both quantitative easing and forward guidance until the economy reached a specific benchmark. It announced that it would buy $85 billion of Treasury bonds and mortgage-backed securities every month if the labor market did not “improve substantially,” and that it would keep rates near zero until the unemployment rate fell to 6.5 percent. At the time, unemployment was 7.8 percent.
That two-part program of stimulus, sometimes referred to as QE3 or QEInfinity, is the boldest, most aggressive stimulus the Fed has undertaken yet. The Fed’s balance sheet has grown drastically over the past nine months since it was introduced:
And over the past nine months, the Fed has succeeded in lowering interest rates on Treasury bonds and mortgages and lifting stock markets.
But now the first stage of winding down the stimulus program is at hand. Since May, Bernanke and other Fed officials have been hinting that they would begin to taper the monthly bond purchases in the early fall. A plurality of investors and economists polled by CNBC now expect the Fed to announce a reduction in the size of monthly bond purchases Wednesday afternoon. Others expect the taper in upcoming months:
Some have questioned whether it is too soon to begin unwinding the stimulus.
Job growth has been slow, at an average of under 150,000 new jobs a month for the past three months. And inflation remains well below the Fed’s 2 percent target — by the Fed’s preferred measure, which strips out energy and food prices to iron out fluctuations, it has been stuck at 1.2 percent for the past few months, near a record low. Narayana Kocherlakota, the president of the regional Federal Reserve Bank in Minneapolis, said earlier this month that the forecasts of unemployment and inflation suggest that the Fed “should be providing more stimulus to the economy, not less.”
For that reason, most investors expect only what Goldman Sachs economists called a “soft taper” in a research note. That is, a relatively small decrease in the amount of monthly bond purchases, from $85 billion to $75 billion.
Few observers would be badly surprised if the Fed held off on slowing its taper until a later date.
And either way, the second part of the stimulus program, the forward guidance, will remain in place. The Fed’s announcement will shed some light on the earliest possible date for a rate hike Wednesday, by releasing its members’ projections of when they expect the unemployment rate to fall below the 6.5 percent threshold.
If the Fed does taper on Wednesday, it would be the first step back toward normal times and toward the end of the Fed’s historic attempts to fix the economy.