Tapering's Impact on the Markets

For several months, Federal Reserve Board (FRB) Chair Jerome Powell has signaled a growing consensus among members of the Federal Open Market Committee (FOMC) that they should begin tapering purchases of bonds downward from $120 billion per month.

On Nov. 3, 2021, Powell announced that the Fed's monthly purchases would decline to $105 billion in December 2021, with further reductions leading to an eventual goal of zero net additions to the Fed's bond portfolio by mid-2022.

Muted Response of the Markets

The major U.S. equity indexes recorded small gains for the day as of the close on Nov. 3, 2021: the S&P 500 Index was up by 0.61%, the Nasdaq by 1.06%, and the Dow Jones Industrial Average (DJIA) by 0.27%. The 10-year U.S. Treasury Note dropped slightly in price, down by 0.16%.

Part of the reason for the muted response of the markets to the tapering announcement is that the Fed has become increasingly transparent in recent years, signaling the markets well in advance about possible policy moves that will affect interest rates. Indeed, as noted above, the Fed has been sending out signals about tapering for much of 2021.

Slowing Down QE

Tapering would gradually slow down an unprecedented program of quantitative easing (QE) that has sent interest rates down to near zero, mainly through massive purchases of bonds by the Fed. QE initially was adopted as a policy response designed to prop up the economy and the securities markets in the wake of the financial crisis of 2008.

As a result of QE, the value of bonds held on the Fed's balance sheet has skyrocketed from $870 billion in August 2007 to $4.2 trillion entering March 2020 and to $8.5 trillion in October 2021.

The Fed Remains 'Accommodative'

During his press conference on Nov. 3, 2021, Fed Chair Powell insisted that, despite tapering, the Fed's stance will remain "accommodative," still seeking to keep interest rates near zero. "It would be premature to raise rates now," he said in response to a subsequent question about inflation.

U.S. interest rates already were at historic lows, near zero, before the Fed began its latest surge in bond purchases in response to the pandemic, thereby doubling the size of its massive balance sheet. The tapering announced on Nov. 3, 2021, will continue to add to the balance sheet and thus seems "accommodative" and consistent with a goal of keeping interest rates roughly stable.

Tapering and Asset Price Bubbles

Since the prices of financial assets—particularly debt instruments such as bonds, but also stocks—tend to be inversely related to interest rates, critics of QE worry that it has created asset price bubbles. Hard assets such as real estate also may have been caught in speculative bubbles, driven by low borrowing rates and low returns on financial assets. Likewise, the rising flow of funds into cryptocurrencies may be yet another consequence of QE. Should tapering actually push interest rates significantly higher, it may pop speculative bubbles driven by historically low interest rates.

Tapering to Reduce Inflation

Inflation has been rising, with the all items version of the Consumer Price Index For All Urban Consumers (CPI-U) recording a 6.2% increase during the 12 months through October 2021, up from 5.4% for the 12 months through September 2021. This was the largest 12-month increase since the period ending in November 1990.

While monetary tightening, such as through tapering, is a possible policy lever to rein in inflation, Powell has indicated that the Fed sees transitory factors such as temporary "supply bottlenecks" as the main drivers of recent price hikes. As a result, he has warned that monetary tightening in hopes of curbing inflation actually may hurt economic growth and employment in the longer term while having little impact on future price increases.

Stocks Perform Better When Interest Rates Rise

Veteran financial markets researcher Mark Hulbert writes, in a recent column: "Conventional wisdom dictates that [interest] rate increases are bad news. Higher rates mean that stocks face stiffer competition from bonds. It also means that stocks are worth less, according to standard discounted cash flow analysis: Higher rates mean that the present value of stocks' future earnings and dividends are lower."

However, Hulbert draws a contrary conclusion from his analysis of data since 1990. "In fact, the S&P 500 has performed better in the wake of Fed decisions to raise the Fed funds rate than in the wake of rate cuts, on average," he finds.

Hulbert notes that the Fed traditionally seeks to raise interest rates amid a booming economy to keep it from overheating. Likewise, the Fed typically cuts rates to stimulate a weak economy. In either case, the upshot of his analysis is that economic fundamentals other than interest rates tend to have a bigger impact on stock prices.

From Tapering to Balance Sheet Reduction

Hulbert cites academic research concluding that "QE appears to have just as much impact on the stock market as cutting the Fed funds rate used to have." In this vein, the next big issue for the Fed will be determining when it becomes appropriate to actually start reducing its balance sheet rather than adding to it at a decreasing rate, which is what the current program of tapering entails. That may have a significant impact on interest rates—and thus also on the economy and the markets.