Curious Capitalist

3 Things to Know About Tapering

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Andrew Harrer / Bloomberg via Getty Images

Note: On December 18, the Federal Reserve announced it would begin reducing its bond-buying program to $75 billion per month.

The stock market has been buoyed by two things in recent months — hopes for a more robust recovery and the Federal Reserve’s $85 billion a month money dump, a program known as quantitative easing (QE). As early as Wednesday, the Fed could make an announcement that it will begin tapering its spending, a shift that would mark the biggest fundamental market change in the past several years. Even if tapering doesn’t come this week, it’s almost certainly coming within the next few months. Here are three things about the end of QE that you need to know:

  1. It could mean a market correction, but it doesn’t have to herald a crash. While the size and scope of this QE program is unprecedented, you can look back in history and see that when the Fed communicates well with the markets, transitions to periods of tighter monetary policy can be accomplished without too much pain. See my post from a few months back on the historical precedents. One of Janet Yellen’s major strengths is as a communicator, something that should serve her well as she steers the Fed away from QE over the next few months and years.
  2. We’ll see a flight from risk. It already happened last summer, when the Fed began to hint about the end of QE. Commodities and emerging markets were hit particularly hard. But U.S. blue chips did O.K. My bet is that while we’ll see a correction in riskier assets, we won’t see U.S. equity markets plunging off a cliff, as much of the expectation about QE ending has been priced in. The bigger question is whether the economic recovery will hold up without the extra stimulus. If it doesn’t, and if you see corporate earnings start to fall as a result, that’s when you should look for a bigger correction.
  3. Interests rates will eventually rise, but not immediately. The Fed has made it very clear that the end of bond and mortgage-backed-security purchases doesn’t have to herald the end of a period of long-term low interest rates. That’s important, because even the recent 1.25 % rise in average U.S. mortgage rates has had a dampening effect on the housing market. With inflation and demand as low as they are now, we may well see relatively low rates into 2015 and beyond.