What Is Federal Reserve “Tapering,” and Why Does It Matter?

   By Frank Holsteen
   Managing Director, Investment Management
 
   October 1, 2021

The financial press has frequently cited concerns about Federal Reserve “tapering” in recent months, leading some investors to rightfully ask why this “tapering” is such a popular topic. As is often the case when talking about central bank policy, the economic details are complicated, but a high-level review can help guide our understanding.

What Is the Federal Reserve?

As the central bank of the United States, the Federal Reserve (Fed) is responsible for the nation’s monetary system and currency—the U.S. dollar. That’s why we see the words “Federal Reserve Note” printed on the top of those paper bills in our wallets.

The Fed serves a powerful and important role in the economy, with the goal of implementing monetary policies that promote strong employment and stable prices for goods and services. A key element of Fed policy is controlling the supply of money in the economy, which includes both the paper bills in our wallets and the deposits recorded electronically at financial institutions like banks.

What Is Quantitative Easing?

In periods of major economic distress, such as the global financial crisis in 2008 or the COVID-19 outbreak in 2020, businesses and households can benefit from the availability of affordable credit in the form of loans or other borrowing. To help promote the availability of credit, the Fed implemented a policy tool called “quantitative easing.”

Through its quantitative easing program, the Fed follows a defined schedule of purchasing a specified quantity of financial assets, such as bonds, from banks and other financial institutions. The process of quantitative easing drives down interest rates and makes credit more affordable, supports prices of financial assets such as stocks and bonds, and ensures banks have plenty of money available to lend.

Since the Fed controls the nation’s money supply, it can pay for its bond purchases with newly created money, thereby increasing the total supply of money. As the economy recovers, aided by business and household spending supported by the availability of inexpensive credit, the Fed needs to contemplate whether quantitative easing could create too much money.

Too much economic stimulus from Fed policy could lead to excesses of borrowing, spending and inflation in the prices of goods, services and financial assets. It’s a balancing act—investors may cheer rising stock and bond markets in the short-term, but long-term investors should also appreciate sustainable growth without excessive imbalances.

What’s the Deal with Tapering?

“Tapering” is a word that the Fed uses to describe a gradual reduction in its pace of purchasing bonds, with an aim to end the quantitative easing program at some point in the future when the economy demonstrates enough stability.

The Fed chooses its words very carefully when discussing its monetary policy plans, focusing on long-term economic stability while trying to avoid the impression that abrupt policy changes will hurt the economy and prices of financial assets. In other words, Fed Chair Jerome Powell and other Fed officials want to prepare investors for changes to policy without sparking short-term panic about stock and bond prices.

We’ll likely continue to hear a lot about tapering in the coming months as indications increasingly point to the Fed gradually ending its current policy of quantitative easing. So, should our participants and institutional investors need to worry about these headlines?

In short: as long-term investors, probably not.

The Fed is clearly seeking to balance all the relevant economic factors as it contemplates gradually adjusting its monetary policy. I’m optimistic that the Fed’s careful wording should reassure investors that it will do its best to avoid acting abruptly and disrupting markets. Either way, we don’t try to forecast short-term market movements here at Wespath. We’ll maintain our disciplined, long-term investment philosophy, which has successfully weathered past periods of uncertainty and should position us well as the Fed moves through the tapering process.