November 23, 2021
What Does the Fed Do When It “Tapers”?
In our previous “Insights” blog, we provided a basic understanding of the Federal Reserve Bank and its objectives. As you recall, the two main objectives are stable price growth and full employment. Taken together, the Fed (with an appropriate monetary policy) may be able to effect and promote sustainable economic growth.
What does the setting of monetary policy mean? The Fed can formally affect the economy with the use of three tools of monetary policy. First, the Fed can adjust the discount rate. Second, the Fed may make changes to reserve requirements for banking institutions. And lastly, the Federal Open Market Committee (FOMC) can perform open market operations to adjust the Fed Funds Rate (FFR). The tool that one may be most familiar with is the changes in the FFR using open market operations (OMO).
What is the Fed doing with open market operations? Essentially, the Fed attempts to adjust short-term interest rates through the buying and selling of securities. The Fed typically buys Treasury or Agency securities through its OMO. The buying and selling of these securities in enough size over certain periods can have an impact of adjusting the FFR. So, if the Fed wants to lower rates at the short end of the yield curve, it will buy the aforementioned securities from primary dealers.
Now that we have discussed the basics of the FOMC and its main policy tool, what happens as the Fed meets its targets for overall economic growth? The Fed wants to make sure the yield curve is upward sloping. This is typically what we see in an economy that is projected to continue a growth trajectory. The FOMC may in fact decide that its current level of asset purchases is no longer needed to promote economic growth and stability.
The Fed is currently purchasing $120B worth of Treasury and Agency securities on a monthly basis. At its most recent FOMC meeting, the committee has indicated that based on the data it tracks, it may be appropriate to begin reducing the amount of monthly asset purchases in their OMO. This is where the term “tapering” comes from as it relates to the reduced amount of bond purchases in the open market.
Ultimately, the Fed sends signals to market participants about its future monetary policy stance. However, tapering in no way means that the Fed immediately ceases its asset purchases in OMO. What it can do is provide for some near-term anxiety and stock market volatility as participants adjust portfolios based on changing expectations of interest rates, for example.
The discussion around FOMC tapering may cause one to feel an elevated level of concern surrounding the effect on one’s investment portfolio and financial plan. But be assured that Gainplan is committed to its investment strategy, and it is this process that will help guide all our investment decisions.