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Fed "tapering": If not now, when?

September 23, 2013

The Federal Reserve's Open Market Committee (FOMC) confounded expectations on September 18 when it decided to maintain its aggressive bond buying program—known as quantitative easing, or QE—in order to keep interest rates low and stimulate the economy.

For perspective on when the Fed might begin scaling back QE and how the "tapering" of this historic monetary policy may affect your portfolio, we spoke with Andrew J. Patterson, an investment analyst in Vanguard Investment Strategy Group.

Were you surprised by anything in the FOMC's statement?

Not shocked. Although the consensus view was that tapering of asset purchases might have begun this month, conflicting data on economic conditions left the door open for a delay in the start of tapering.

Quantitative easing refers to the Federal Reserve's purchase of securities, including Treasury bonds and mortgage-backed securities, in an effort to stimulate economic activity in an environment of near-zero interest rates.

Tapering refers to a gradual reduction in the monthly purchase of assets by the Fed.

Andrew Patterson Fed officials have been clear in stating that any change in policy will be dependent upon economic conditions at any given time. There is no timetable in place, and even when tapering does begin, there is no set path. The Fed would stand just as ready to increase asset purchases as to decrease them should economic conditions warrant.

Why has there been so much attention on tapering recently?

In May testimony before the Joint Economic Committee of Congress, Fed Chairman Ben Bernanke first mentioned the possibility of tapering. In subsequent communications, perhaps most notably following the June FOMC meeting, he and other Fed officials continued to discuss the idea, citing the rationale that the downside risks of economic conditions were still present but waning. The minutes from that meeting didn't provide firm dates for a plan of monetary tapering but instead reiterated the framework the Fed had originally presented in 2011.

The unconventional monetary policies we've experienced in the past several years have to be rolled back at some point. As the economy gradually regains the ability to stand on its own—at least in the Fed's view—the Fed will inevitably start the gradual process of removing the quantitative easing measures.

What does the long-term exit framework look like?

Right now, $85 billion in assets are being added to the Fed's balance sheet each month—$45 billion in Treasuries and $40 billion in mortgage-backed securities (MBS). The first step in the Fed's exit framework would be to decrease the level of asset purchases each month, or taper them. Consensus expectations are for this to occur sometime before the year-end. However, Bernanke made clear that U.S. monetary policy will be driven by overall economic conditions, not by any one threshold or data point. So, that timing may change based on a range of factors.

Keep in mind: Tapering means the Fed will still be purchasing assets, just not as many. In the Fed's eyes, a tightening of policy does not occur until its balance sheet shrinks and, soon after, short-term policy rates start increasing. This is not likely to occur until mid- or early 2015. After the tapering phase concludes, the Fed's next step would be to reinvest maturing securities in like securities, keeping the size of its balance sheet steady for some time. The whole process should be quite gradual: Tapering may last for six to nine months, maintaining a steady balance sheet may persist for another six to nine months, and then the Fed may raise its target federal funds rate sometime in 2015.

Several major stock indexes rose by approximately 1% the day Bernanke announced that tapering would not yet begin. Does this reflect investors' relief after the shock the market experienced following the June discussion?

We don't like to say any one factor alone drives financial markets, but this certainly had an impact. Most people didn't foresee the volatile market reaction that occurred after the June FOMC statement—in fact, Bernanke has said that he was taken by surprise.


The Fed announced that economic conditions are not yet ripe to begin reducing the billions of dollars of Treasuries and mortgage-backed securities it buys each month.

The Fed has made clear that it stands just as ready to increase its asset purchases as to taper them. Once tapering begins, it is not a signal of the imminent tightening of monetary policy.

Tapering will be a gradual process, followed by keeping the balance sheet steady, and then eventually increasing the target rate.

The Fed believes it's the level of assets on its balance sheet that should be affecting markets, not the purchases themselves. The markets may not always realize this, but once tapering does begin, the Fed stands just as ready to increase asset purchases as to taper them. The Fed doesn't have a set time frame or policy—its next steps will be dependent on economic conditions at any given time, so the volatility, manifested through such a large shift in interest rates in such a short period of time, was surprising.

That said, another major tool of the Fed during this period of unconventional monetary policy has been communications regarding forward guidance, or setting expectations for interest rate policy. The volatility following Bernanke's comments in May and the FOMC statement in June helped show how much the guidance of the committee could affect the financial markets. Despite the communication efforts of Fed officials, market participants may perceive the beginning of tapering as a signal of imminent policy tightening. At the same time, Bernanke has continued to emphasize that changes in monetary policy will not be based on potential financial-market impacts, but in regard to overall economic conditions.

Has the Fed shared specific conditions or thresholds it plans to use?

Although the Fed now is much more transparent than it was in the past, it tends not to announce policy until it's time to implement it. After all, one of the tools in the Fed's toolbox is expectations. It needs to manage expectations around inflation as well as around when tapering and tightening will occur. In an indirect way, the Fed has given us some clues: It has said it expects to end tapering when the unemployment rate is around 7%, and its forecasts show that occurring by the middle of next year. So that's a way it has of giving hints.

What should investors keep in mind?

No one really knows how the Fed's exit strategy will play out. While yields have risen since the beginning of the year, they're still at historically low levels. While Vanguard looks at various scenarios, we don't know for certain when or at what speed interest rates are going to increase or how the shape of the yield curve or credit spreads will evolve. Without knowing those things, we don't believe we have the ability to say with certainty which bet might pay off and at what time. We can only provide an educated guess while maintaining a focus on potential risks.

With that in mind, Vanguard believes the smart choice for investors is to stay diversified. Return expectations for bonds in the medium term may be muted, but bonds offer important diversification benefits, with the potential to offset large swings in equity returns. (For more information, see "Bonds and risk: Putting interest rate changes in perspective".) The "cushion" they provide may not be as thick as it has been in the past, but bonds do still provide protection in your clients' portfolios.

What's the main take-away?

Remember that tapering alone does not signal an increase in interest rates. Markets and economic conditions work to determine interest rates across the yield curve while monetary policy reacts to economic conditions. While interest rates will likely increase, we do not know with certainty when or at what speed. The Fed's exit strategy won't just zoom ahead once it's been placed in drive. Instead, the Fed will be constantly analyzing economic conditions and adjusting policy accordingly.



  • All investing is subject to risk, including possible loss of principal. Past performance is no guarantee of future returns. Diversification does not ensure a profit or protect against a loss.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
  • While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.
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