Let's "taper" talk

“Fed Taper” talk is in the air again, well at least the talking about talking about phase which can be interpreted to mean that the U.S. Federal Reserve Bank (the Fed) is merely considering tapering rather than seriously deciding to do anything about it. But what is “tapering”, when is the Fed likely to begin and what are the implications for markets, if any?

What is tapering?

Central banks periodically buy large quantities of bonds on the secondary market to inject liquidity and support financial markets during economic crises. The Fed for instance has been buying bonds amounting US$120B per month since March 2020 in response to global economic meltdown caused by the covid-19 pandemic. These bond purchases, however, are intended to be emergency responses and so as the economic environment improves and appears sustainable, the need for such extreme measures is no longer warranted and may even have their own economic consequences, such as persistent high inflation, if left unchecked. So, with the U.S. economy rebounding swiftly and sharply, the Fed will eventually end its monthly bond buying program. It will however gradually reduce or “taper” monthly purchases to create minimal market disruptions. Tapering can therefore be viewed as the act of a central bank buying fewer assets each month to unwind a quantitative easing (QE) program.

When is tapering?

The speed of the economic rebound of the U.S. economy and the ongoing spike in U.S. inflation have fueled speculation that the Fed will need to withdraw monetary stimulus sooner rather later to avoid current elevated levels of inflation becoming persistent. And so, many market observers were expecting Fed officials to discuss a “taper” plan at their June meeting, particularly since officials were armed with May’s inflation data which were at their highest levels in decades. Talks did not materialize however as the just released minutes of the meeting revealed that officials believed that “substantial further progress” still needs to be made.

In that regard, it appears that the U.S. labour market holds the key to the timing of the withdrawal of monetary policy accommodation as well as the outlook for inflation. The U.S. labour market has been recovering at a remarkable pace amid the rapid pace of vaccination and ongoing government support. Consequently, the unemployment rate has fallen from a pandemic high of 14.8% in April 2020 to 5.9% in June 2021. Despite, the progress being made, the U.S. economy is still about seven million jobs short of what it was just prior to the pandemic. Also, the unemployment rate was at 3.5% prior to the pandemic. Small wonder therefore the Fed believes that considerable slack remains in the labour market which will require a lot more policy accommodation and time to remedy. 

Notwithstanding, at its last meeting, the Fed considerably raised its expectations for inflation this year and brought forward the time frame when it will next raise interest rates from 2024 to 2023. Using this rate hike time frame and the Fed’s expected gradual approach, one can then deduce when tapering is likely to start.

As observed from the last taper cycle of 2013-2014, the Fed is unlikely to simultaneously raise rates while tapering bond purchases. Additionally, the Fed tapered at rate of $10 million per month. If that pace is repeated, which is more likely than not, tapering should last one year. Fed officials indicated two hikes in 2023 which I suspect the first will likely come in September 2023 and the next in December 2023. However, the Fed does not want to surprise markets and perhaps will give at least 6 months’ notice before moving on rates as it did in 2015. That makes March 2023 a reasonable end date for tapering and March 2022 as the likely start date, assuming tapering lasts for one year. Incoming inflation data may however accelerate or delay those timelines.

What is the impact of tapering?

The announcement of tapering in May 2013 initially brought much anxiety to financial markets. Bonds sold off sharply in the wake of the then Fed chairman first mention of tapering as yields jumped, while stocks began to exhibit higher volatility than before. However, the markets subsequently stabilized through the second half of 2013, as investors gradually grew more comfortable with the idea of a reduction in the Fed’s bond buying program. Tapering was novel in 2013 and so the initial fear response was perhaps justifiable. This time around investors have some historical reference as guide and so I do not foresee any meaningful adverse market responses to the upcoming taper event.

Eugene Stanley is the VP, Fixed Income & Foreign Exchange at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm

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