Federal Reserve Tapers to Combat Inflation

Federal Reserve Tapers to Combat Inflation

November 4, 2021

Tapering? Inflation? Recession? There is a lot of noise about the Federal Reserve, the Fed, tapering or slowing its asset purchases, and a lot of it seems to be grim news. We give you the basics below.

What is the Federal Reserve?

The Fed is the central banking arm of the United States, and it operates outside any of the three branches of government to remain as independent of political changes as possible. In short, the Fed’s mission is to be the lender of last resort, promote full employment, and promote price stability.

Tapering

Tapering simply means any policy that a central bank enacts to modify existing implementations. Currently, tapering refers to the slowing of the Federal Reserve’s policy of purchasing securities (called Quantitative Easing, or QE). QE is initiated when interest rates cannot be lowered further and below 0.25%, and the economy is still not recovering sufficiently.

Purchasing securities (such as treasury bonds or mortgage-backed securities) is one way the Fed pushes and keeps interest rates down, which allows consumers and businesses alike to borrow money cheaply. The other beneficiary is the US Federal Government which is allowed to float its massive borrowings at low-interest rates with the very real possibility that the debt held at the Fed will never have to be repaid, and the Fed will just roll it over into perpetuity.

The intended effect is more money is injected into the economy, allowing businesses to hire more and consumers to buy more goods and services from those businesses – fulfilling price stability (at least during a recession and deflationary environment) and the full employment part of its mandate. Tapering is similar, just in smaller doses.

The Federal Reserve will begin reducing the number of new securities purchased, to raise interest rates and hopefully cool off inflation and record high price levels. It is like an addict trying to moderate their overindulgence without outright abstinence.

Hotel California

To say the least, this will be difficult. We have a couple of video links about the Fed’s Hotel California moment. One in 2012 and one from 2019 when the Fed was starting to Taper before COVID-19. 

In this case, the Fed will reduce its $120 billion in monthly purchases, down by $15 billion a month. While this does not seem like a huge change, the Fed has nearly doubled its balance sheet since March of 2020, to over $7 trillion and up from $800 billion in 2008 before the financial crises.

Tapering Risks

The Fed is between a rock and a hard place. If the current QE program is maintained, inflation could take off. If tapering or ending QE happens before the economy is self-sustaining, the economy could slow and unemployment increase. The major question among economists and investors alike is how effective will raising interest rates be for controlling inflation, and how will it affect recovery?

Inflationary and Volatility Concerns

Inflation has spiked from the COVID-induced recessionary low, with some consumer goods like gasoline up 80%. As a result, overall inflation is estimated to be as high as 5% (officially, up to 3.7% from the initial projection of 3%).

When the Fed began to taper in 2013 – it was dubbed the “Taper Tantrum.” Then chair Ben Bernanke suddenly announced the end of QE during a congressional hearing causing a stir in markets and significantly increased volatility. This time though, the Fed has telegraphed its intentions for a long time with only the timing in doubt. Now that it is here, the stock market has not reacted adversely, at least yet. Howeverand this is an important however – if the short-term tapering turns out to be inadequate to tame rising inflation pressures, this will be an indication that the Fed has lost control of inflation and more draconian measures of actual balance sheet reduction and higher interest rates are required. This could spell disaster for financial markets.

The Fed’s optimistic view is calling the record-high inflation transitory and the recovery solid enough to reduce asset purchases. The markets seem to agree with bond interest rates remaining low and stock prices high. However, if higher inflation is pervasive and longer than transitory, the market adjustments will be painful for investors. If the Fed is forced to go cold turkey on asset purchases, investors will suffer withdrawals.

Investors are undoubtedly addicted to low rates and Quantitative Easing; weaning them of this liquidity addiction will be difficult.

“You can check out anytime you like, but you can never leave,”

The Eagles, Hotel California