From the beginning of the Covid-19 crisis until November 2021, the Federal Reserve purchased a little more than $4 trillion of Treasury and mortgage-backed securities to stabilize financial markets and stimulate the economy.
Now, as the economy recovers, the need for those large-scale monthly purchases at the same rate diminishes. But slowing the pace presents challenges. In the recovery from the Great Recession, the announcement that the Fed was considering tapering its security purchases sent the markets into a “tantrum” that caused a spike in interest rates in Treasury bonds.
Will history repeat itself?
Pandemic-led shutdown
The Fed began the most recent stimulus in March 2020 to stabilize financial markets that were facing turbulence in the Covid-19 pandemic. With the realization that the shutdowns necessitated by the Covid-19 pandemic would plunge the U.S. economy into a recession, and facing uncertainty about how deep the contraction might be and for how long, key financial markets pulled into their shells, turtle-like, in the spring of 2020.
At first there was a significant decline in both bond yields and in stock market values — the expected response for both in the face of incipient economic turbulence as investors seek the safety and liquidity of Treasuries.
But between March 9 and 18, stresses led to a surprising 0.64 percentage point increase in the 10-year Treasury yield, from 0.54% to 1.18%, even as the stock market continued to fall. This sudden spike in Treasury yields has been attributed in part to large sales of Treasury securities by investors facing immediate liquidity needs (see here).
In response to the crisis, the Federal Reserve quickly mobilized programs, both tested and novel, to restore financial market function and make sure that the supply of credit continued to flow to businesses. The Fed’s purchase of $1 trillion of Treasury securities by the end of the first quarter of 2020 met the goal of restoring financial market function for the stressed Treasury market.
Cheap borrowing costs
Long after financial markets had stabilized, the Federal Reserve continued with massive purchases of longer-term Treasury securities and U.S. government-insured mortgage-backed securities, which also served the purpose of stimulating the macroeconomy. Purchases of Treasuries and mortgage-backed securities (MBS) are intended to keep longer-term interest rates low, so that businesses that continue to borrow can do so at favorable rates.
When the Fed purchases Treasuries and MBS that are in high demand by private markets, they of course become scarce, leading investors to accept even lower interest rates as inducement to purchase. Those low long-term rates kept the economy from sinking even deeper into recession, preventing greater loss of employment.
For that reason, the rapid buildup of purchases of Treasury and mortgage-backed securities at the onset of the crisis was followed with a continued steady pace of security purchases since the summer of 2020.
The Federal Reserve made the pace of these purchases explicit in December 2020 when it announced that it would be purchasing Treasury and mortgage-backed securities at a pace of $80 billion and $40 billion, respectively, each month. (Prior to that, it had stated that it was purchasing these securities “in the amounts needed to support smooth market functioning” — April 29, 2020 — and “at least at the current pace” from June through November 2020.)
Taper talk
As the economy showed signs of recovery, the Federal Reserve signaled that it would shift toward a gradual reduction in the pace of asset purchases, or “tapering.” While the contraction in economic activity in the spring of 2020 was extremely rapid, so too was the rebound: Just one year after the downturn, real GDP had more than regained its pre-pandemic level.
As is common in downturns, the unemployment rate has taken somewhat longer to recover. But one year after a 10 percentage point rise in unemployment, the jobless rate had recovered smartly, dipping to 4.2 percent in November 2021. The rapid rebound in demand, coupled with some key supply shortages — in labor as well as in key inputs to production — has led to a surge in inflation that is larger than we have seen in 30 years.
In recognition of the recovery in economic conditions, the committee in its Sept. 22, 2021, statement suggested that an “adjustment [in its asset purchases] may soon be warranted.” At its November 2021 meeting, the committee announced that it would slow the pace of purchases to $70 billion and $35 billion per month, respectively, and expects to slow the pace further to $60 billion and $30 billion in December, further tapering purchases by $10 billion and $5 billion, respectively, in each of the ensuing months. This gradual slowing in the pace of purchases is precisely the taper that markets have expected and discussed for some months.
While this tapering will decrease the size of monthly purchases, it will leave most of the rather large stock of Treasuries and MBS that the Fed now holds on its balance sheet. So, why taper?
Reducing the pace of purchases should provide a bit less stimulus to the economy, by exerting less downward pressure on long-term interest rates. This modest adjustment to the Fed’s policy stance is unlikely to have dramatic effects on business sales and employment, but it will take a little steam out of the economy.
2013 vs. today
Why did this seemingly simple and small adjustment to the Fed’s asset purchase garner so much attention in financial markets? To understand this, we have to roll back a few years to a parallel period in U.S. economic history, during the recovery from the Great Recession and financial crisis.
The Fed, during that earlier episode, had purchased a similar total amount of Treasuries and MBS, albeit spread over a much longer period. As unemployment fell in late 2012 and early 2013, it looked like it might soon be time to pull back a bit on the stimulus that asset purchases provided.
While then-Chairman Ben Bernanke had attempted some earlier signals, he announced on May 22, 2013, that the Fed would begin tapering its asset purchases at some future date. The suggestion that they were considering ending those purchases sent Treasury markets into the so-called “taper tantrum.”
On that day, the yield on 10-year Treasurys
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1.483%
began to rise, ultimately increasing by more than 1 percentage point over the next seven months. That was the “tantrum”: At the announcement of what seemed a relatively uncontroversial and gradual adjustment to monetary policy, markets both immediately and over the ensuing months priced in considerably higher interest rates.
Does the initial market reaction to tapering in the recovery from the Covid recession resemble the reactions to tapering following the Great Recession? If we look at the most recent period, dating the announcement of the intent to taper at the September 22 FOMC statement, we can see that at first, this episode closely mirrored its cousin in 2013.
Yields stay stable
But the episodes now differ in important ways. In the current case, the Fed began tapering its purchases just six weeks after announcing its intent, eliciting little or no response from Treasury rates, which have moved more-or-less sideways since a few days after the September announcement.
In the 2013 episode, the 10-year rate continued to rise to 3% by year-end (the orange dot in the chart, above) — more than a percentage point higher than pre-announcement — even though purchases continued well into 2014 and actual tapering came much later than in the current episode.
Given the recovery and apparent ongoing strength of demand in the economy, and no doubt with a nod toward elevated inflation and the (as yet incomplete) stimulative fiscal packages that are in train, the tapering that the Fed initiated seems a prudent policy action.
A high degree of uncertainty remains, especially given the inherent unpredictability of the public health situation. I hesitate to predict the future course of the 10-year Treasury yield, as we are relatively early on in this tapering episode. But since the announcement was quickly followed by actual tapering in this case, and the response thus far has been fairly muted, it seems less likely that the market will react too much more to the continued, gradual reduction in purchases.
Time will tell.
Jeffrey C. Fuhrer is a senior fellow at the Mossavar-Rahmani Center for Business and Government at the Harvard Kennedy School. He is a former executive vice president of the Federal Reserve Bank of Boston. His research focuses on monetary policy, inflation, consumer spending and asset prices.
This article was published with the permission of Econofact.
