Here’s What the Fed Means by Tapering
The Federal Open Market Committee announced it is beginning to taper! But wait—what exactly is tapering? Tapering means gradually reducing the pace of the Fed’s securities purchases.
The Fed has been purchasing large amounts of U.S. Treasury securities and agency mortgage-backed securities each month during the COVID-19 pandemic, aiming to support the flow of credit to households and businesses during this time of severe stress in the economy. Tapering reduces the amounts regularly purchased.
Here’s some background on how the Fed’s actions help the economy, why the Fed buys securities, what types of securities the Fed buys and how tapering will work.
The Federal Reserve and Monetary Policy
Let’s look at what the Federal Open Market Committee, or FOMC, the main monetary policymaking body of the Federal Reserve, may do when the economy weakens.
The FOMC’s first action may be to lower its target range for the federal funds rate, which is the interest rate that banks charge each other for overnight loans. Lowering the target range puts downward pressure on short-term interest rates, which encourages spending by consumers and firms.
The target range for the federal funds rate can be lowered all the way to near zero. But sometimes more needs to be done. When economic conditions warrant further actions, the FOMC turns to “balance sheet policy” to influence longer-term interest rates, stabilize financial markets, or both. The securities the Fed purchases are reported on its balance sheet as an asset. Securities the Fed holds make up the vast majority of the Fed’s assets.
What Securities Does the Fed Buy?
In response to the global financial crisis and subsequent recession in 2007-09, the FOMC both lowered the target range for the federal funds rate to near zero and conducted several large-scale asset purchase programs. Through these programs, the Fed purchased:
- U.S. Treasury securities
- Agency mortgage-backed securities, or MBS, which are based on pools of home mortgages and guaranteed by government-founded Fannie Mae and Freddie Mac and government agency Ginnie Mae
- Federal agency debt securities, which are direct obligations of Fannie Mae, Freddie Mac and the Federal Home Loan Bank
The FOMC took similar actions during the pandemic, including reducing the target range for the federal funds rate to near zero and purchasing Treasury securities and MBS. (For more information on all of the Fed’s monetary policy actions in response to the pandemic, see our August 2020 Open Vault blog post with Gretchen Weinbach.)
Why Does the Fed Buy Securities?
When the Fed purchases securities, its holdings increase while those of the private sector decrease. You can see the expansion of the Fed’s holdings in the area chart below, which shows total securities holdings rising from $3.8 trillion in February 2020 to $8.0 trillion as of the end of October 2021.
The purchases of Treasury and mortgage-related securities pushed down longer-term borrowing rates for millions of American families and businesses. That is, in order for private investors to be willing to sell the Fed a sizable amount of securities, the price is bid up, which means the yield (earnings expressed as a percentage of the amount invested) on those securities falls.
What Is Tapering?
The Fed will only purchase securities as long as it is deemed necessary. On Nov. 3, 2021, the FOMC stated that the large monthly purchases of securities that the Fed has been making since the start of the COVID-19 crisis would begin to slow. “In light of the substantial further progress the economy has made toward the Committee’s goals of maximum employment and price stability,” the FOMC committed to begin reducing the pace of asset purchases.
In particular, it announced that it is decreasing the amount of Treasury and MBS purchases in November and December. The FOMC statement also suggested that there could be further reductions in coming months if the economic outlook continued to improve.
How Will Tapering Work?
The first step in the tapering process will be taken in mid-November, when the Fed will reduce the pace of purchases.
- Treasury securities purchases will go from $80 billion to $70 billion a month.
- MBS purchases will go from $40 billion to $35 billion a month.
Then, in mid-December, the pace of purchases will be reduced again.
- Treasury securities purchases will go from $70 billion to $60 billion a month.
- MBS purchases will go from $35 billion to $30 billion a month.
If the economy continues to improve as the FOMC expects, then each month the pace of purchases could decline by similar dollar amounts. Assuming the recovery remains on track and the FOMC continues its monthly tapering pace, by mid-2022 the Fed will complete the taper and no longer be purchasing securities that increase the size of its balance sheet. At some point in the future, the FOMC will need to decide when to reduce the size of its securities holdings. The Fed’s current policy is to reinvest all funds from maturing and prepaying securities into new securities. This action keeps the Fed’s securities holdings constant. When the FOMC chooses to allow some or all those securities to be redeemed, the Fed’s securities holdings will decline.
What Is Next?
After the taper is complete, and assuming the economy continues to improve, Fed watchers are thinking about when the FOMC will raise the target range for the federal funds rate from its near-zero level (also known as “liftoff”). But as Fed Chair Jerome Powell has said, these are independent policy decisions; the timing and pace of tapering is not intended to signal anything about the timing of interest rate liftoff.
Note1 At some point in the future, the FOMC will need to decide when to reduce the size of its securities holdings. The Fed’s current policy is to reinvest all funds from maturing and prepaying securities into new securities. This action keeps the Fed’s securities holdings constant. When the FOMC chooses to allow some or all those securities to be redeemed, the Fed’s securities holdings will decline.
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