The Federal Reserve has been purchasing US bonds in huge amounts since early 2020, increasing its holdings to $8.5 trillion. This practice is intended to stimulate the nation’s economy during times of serious trouble, which the pandemic certainly delivered.
Now, as the Fed talks of cutting back bond purchases by $15 billion monthly in order to “taper” off its economic stimulus, investors wonder what impact that could have on the stock market. What will Jerome Powell’s tapering process look like for investors?
TL;DR
- The Federal Reserve began a massive bond buying program to offset the pandemic-induced recession and increase the money supply.
- Federal Reserve Chairman Jerome (Jay) Powell has aimed at transparency, warning that the central bank would eventually ease up on bond-buying.
- The Fed approximately doubled its bond holdings to $8.5 trillion since the start of the pandemic in early 2020.
- The Federal Open Market Committee said it would begin tapering, or cutting back on bond purchases, by $15 billion per month by the end of 2021.
- Many analysts believe the bond program has been successful, though it’s hard to know how much of the economy is due to the Fed’s actions compared to Congressional stimulus spending.
Why the Fed began its bond purchasing program
The Federal Reserve launched its efforts to stimulate the economy through bond purchasing to fulfill its mandates. The two primary Fed mandates are maximum employment and price stability, which it typically has accomplished through interest rate manipulation and open market operations.
Lowering federal interest rates wasn’t much of an option at the start of the pandemic, since rates were already close to zero. Therefore, to offset the pandemic’s harsh impact, the Fed started buying Treasury bonds in the open market (its second primary tool for accomplishing its goals).
Buying bonds was the Fed’s way of increasing the money supply during a period when millions of Americans were unemployed and strapped for cash.
The process of buying bonds is also referred to as quantitative easing (QE). Prior to the pandemic, experts generally viewed QE as an unconventional monetary policy.
However, Roosevelt Institute economist Mike Konczal said at a Congressional hearing that the bond-buying program, including the addition of municipal and corporate bonds, should be a permanent part of Fed policy. He cited the overall success of the Fed’s programs as the reason the program will likely become more conventional and commonplace.
How and why the Fed is trying to unwind the stimulus
As Tom Garreltson, senior portfolio strategist at RBC Wealth Management, said in September, the Fed’s bond-buying stimulus action “served its purpose.”
After a year and a half of purchasing $120 billion in government bonds, the Fed believes it’s time to unwind the stimulus by gradually easing up on its bond purchases. In December 2020, the Fed voted to keep short-term borrowing rates near zero and vowed to continue buying bonds at the same rate.
Chairman Powell also gave assurances that before beginning the Fed tapering process, they would give plenty of advance notice.
Currently, Powell says the board will continue to be “accommodative” by aiming to keep interest rates at their near-zero low. Rates were already near zero when the Fed ramped up bond purchasing early in 2020.
The Federal Open Market Committee (FOMC) said that it would begin reducing its Treasury securities purchases by $10 billion monthly. The committee’s reasoning was that it has achieved “substantial further progress” towards its goals: maximum employment and an average 2% inflation rate. As of November 2021, the 12-month inflation rate is 6.2%, the highest since 1990.
The remaining $5 billion in reduced securities purchases will come from the central bank, for a total of $15 billion less each month until the stimulus of bond-buying has phased out completely by mid-2022. Chairman Powell has reserved the right to slow or speed up the Fed bond taper as warranted by economic conditions.
Powell also explained that although the Fed believes it’s time to taper, it’s not yet necessary to raise interest rates because the organization wants to inch closer to its employment goals.
Why some investors view tapering as a risk to the stock market
If you’ve been paying attention to economic news, you may have noticed that the stock market goes into a bit of a tizzy every time Powell mentions the word “tapering.”
The stock market saw some increases after the early November 2021 tapering announcement.
At the close of markets on November 3, the S&P 500 was up by 0.61%, the Nasdaq by 1.06%, and the Dow by 0.27%.
Some believe the markets had a moderate response to the tapering news rather than a dramatic correction because of the Fed’s increased transparency. It notifies markets in advance of policy moves that could impact rates and returns.
Previous tapering warnings caused some selloff, though that was more about sentiment than actual impact. After all, the tapering process hadn’t had time to change the scope of the economy.
Mark Hulbert, a financial markets researcher, shares data indicating that “QE appears to have just as much impact on the stock market as cutting the Fed funds rate used to have.”
Some analysts believe the tapering could be bad for the stock market. Eddie Ghabour, a managing partner for KeyAdvisors Group, says the process of winding down the stimulus tool could result in a 15–20% market correction in the beginning of 2022. He claims that higher prices, lower growth, and the tightening of the Fed’s stimulus will be “the worst equation for the market.”
Bottom line
As the Federal Reserve begins implementing its plans of tapering bond purchases that have doubled its holdings during the pandemic, investors should keep their finger to the pulse of the Fed. The process may not have a severe impact on the stock market, but it’s wise to follow any information the Fed releases and adjust investment plans accordingly. Short-term investors are more prone to volatility as it relates to earnings, news, and—of course—the Fed’s economic outlook.