This post was updated on August 30, 2021.
Research Analyst - The Hutchins Center on Fiscal and Monetary Policy
In response to the economic impact of the COVID-19 pandemic, the Federal Reserve cut short-term interest rates to zero on March 15, 2020 and restarted its large-scale asset purchases (more commonly known as quantitative easing, or QE). Since July 2021, the Fed has been buying $80 billion of Treasury securities and $40 billion of agency mortgage-backed securities (MBS) each month. As the economy rebounded in mid-2021, Fed officials began talking about slowing—or tapering—the pace of its bond purchases.
Why does the Fed buy long-term debt securities?
Quantitative easing helps the economy by reducing long-term interest rates (making business and mortgage borrowing cheaper) and by signaling the Fed’s intention to keep using monetary policy to support the economy. The Fed turns to QE when short-term interest rates fall nearly to zero and the economy still needs help.
By buying U.S. government debt and mortgage-backed securities, the Fed reduces the supply of these bonds in the broader market. Private investors who desire to hold these securities will then bid up the prices of the remaining supply, lowering their yield. This is called the “portfolio balance” effect. This mechanism is particularly important when the Fed purchases longer-term securities during periods of crisis. Even when short-term rates have fallen to zero, long-term rates often remain above this effective lower bound, providing more space for purchases to stimulate the economy.
Lower Treasury yields are a benchmark for other private sector interest rates, such as corporate bonds and mortgages. With low rates, households are more likely to take out mortgage or car loans, and businesses are more likely to invest in equipment and hiring workers. Lower interest rates are also associated with higher asset prices, increasing the wealth of households and thus driving spending.
Bond purchases can impact market expectations about the future path of monetary policy. QE is seen as a signal from the Fed that it intends to keep interest rates low for some time. Overall, the large-scale asset purchases that took place during and after the global financial crisis had powerful effects on lowering 10-year Treasury yields.
Figure 1 shows the expansion of the Fed’s asset portfolio since 2008.
The Fed’s current bond purchases differ in composition from earlier QE programs. While previous rounds of QE primarily involved the purchase of longer-term securities, the Fed is currently purchasing Treasuries across a broader range of maturities. This was driven by the Fed’s original goal of calming a distressed Treasury market in March 2020.
Figure 2 shows the changing composition of the Fed’s Treasury holdings since 2000.
What is tapering?
Tapering is the gradual slowing of the pace of the Federal Reserve’s large-scale asset purchases. Tapering does not refer to an outright reduction of the Fed’s balance sheet, only to a reduction in the pace of its expansion. At some point after tapering is complete, the central bank is likely to gradually reduce the size of its balance sheet by letting maturing securities “run off” the balance sheet without replacing them, as it did from October 2017 until September 2019.
The Fed’s motivation for tapering is to slowly remove the monetary stimulus it has been providing the economy. Specifically, according to guidance the Fed issued in December, tapering will begin when the economy has made “substantial further progress” toward its goals. Some members of the Fed’s policy setting committee, the Federal Open Market Committee (FOMC), have noted that employment remains far below the pre-pandemic level, suggesting that patience is needed. Other members have expressed concern about inflationary pressures and excessive risk-taking in financial markets as a result of the Fed’s asset purchases.
The Fed has made clear that tapering will precede any increase in its target for short-term interest rates. So tapering not only reduces the amount of QE, it is also seen as a forewarning of tighter monetary policy to come, as was observed in the aftermath of the Great Recession. The combination of projected reductions in asset purchases and the possibility of higher rates in 2013 led to a period of high volatility and rising rates in the bond market—an episode that became known as the taper tantrum.
What was the taper tantrum?
In response to the global financial crisis, the Fed began purchasing Treasury securities and mortgage-backed securities in 2009. There were three rounds of purchases dubbed QE1, QE2, and QE3. The first two were for pre-announced totals. The third, launched in September 2012, was open-ended; the Fed said it would keep buying bonds until labor market conditions improved.
In Congressional testimony on May 21, 2013, Chair Ben Bernanke gave the first public signal that a taper was on the horizon. “If we see continued improvement and we have confidence that it is going to be sustained, then we could, in the next few meetings, take a step down in our pace of purchases,” he said.
Bernanke’s words, apparently surprising the markets, set off an increase in market interest rates known as the taper tantrum. The bond market pushed 10-year Treasury yields up slightly, from 1.94 percent on May 21 to 2.03 percent on May 22, 2013. Following the June FOMC meeting, Bernanke elaborated on the plan for tapering and yields rose more substantially, eventually hitting 2.96 percent on September 10. This occurred despite efforts by Bernanke and other FOMC members to emphasize that any reduction in asset purchases would be gradual and that an increase in the Fed’s target for short-term rates was not imminent.
The impacts of the taper tantrum on the U.S. economy were relatively mild, with the economy growing at a rate of 2.6 percent in 2013 (on a Q4/Q4 basis) despite fiscal as well as monetary tightening. But it had greater effects on financial markets abroad where the increase in Treasury yields drove capital outflows and currency depreciations, especially in emerging markets such as Brazil, India, Indonesia, South Africa, and Turkey.
In December 2013, the Fed began to taper, reducing the pace of asset purchases from $85 billion per month to $75 billion per month. Purchases were reduced by a further $10 billion at each subsequent meeting (in February 2014, Janet Yellen took over as chair). The asset purchase program ended in October 2014, and the Fed began shrinking the balance sheet in October 2017.
What will tapering mean for the timing of Fed rate hikes?
As the U.S. has begun to emerge from the COVID-19 pandemic, the economy has picked up more rapidly than initially expected, leading the Fed to consider removing some of its monetary stimulus. In June 2020, the FOMC forecast that real gross domestic product (GDP) would fall by 6.5 percent in 2020. Similarly, in July 2020, the Congressional Budget Office (CBO) projected that real GDP would fall 5.9 percent for the year. Real GDP actually fell by just 2.4 percent in 2020 and grew rapidly in the first two quarters of 2021. This has led the market and FOMC to evaluate the eventual tapering of asset purchases and raising of interest rates.
Distinguishing short-term interest rate policy from tapering has been a communication challenge for the Fed dating back to the taper tantrum. This time, the FOMC has repeatedly indicated that tapering will precede any consideration of rate hikes. Fed chair Jerome Powell stated in April 2021 that tapering will occur “well before the time we would consider raising rates.”
In his speech at the Federal Reserve Bank of Kansas City’s Jackson Hole conference on August 27, 2021, Powell again noted this distinction: “The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test.”
How will tapering influence long-term interest rates?
Tapering can impact long-term interest rates through both its direct effects on bond markets and the signal it provides about the Fed’s future policy intentions.
Since tapering refers to the slowing of the Fed’s bond purchases rather than the reduction of its holdings, the Fed’s balance sheet is still growing, and thus the Fed is providing monetary stimulus to the economy. This could restrain any upward pressure on long-term rates from the Fed’s tapering. There is evidence to support this idea: a 2013 study by Fed economists found that the size of the balance sheet is more important than the pace of purchases in lowering long-term yields.
However, long-term rates also reflect market expectations about the course of short-term rates. Since tapering can signal to markets that the Fed is shifting to a less accommodative policy stance in the future, this could lead to a rise in long-term rates as occurred during the taper tantrum.
The minutes of the July 2021 FOMC meeting indicate that the Fed’s internal models prioritize the stock view of asset purchases. “In the staff’s standard empirical modeling framework, the effect of asset purchases on financial and economic conditions occurred primarily via their influence on the expected path of private-sector holdings of longer-term assets […] Changes in the flow of asset purchases could also influence yields, but this influence would likely be modest outside of periods of stressed financial market conditions.”
What has the Fed said about when it will begin tapering?
In December 2020, the Fed said it would continue to increase its holdings of Treasury securities by at least $80 billion per month and of agency mortgage-backed securities by at least $40 billion per month “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.” In its July 2021 FOMC statement, the Fed said that “the economy has made progress toward these goals, and the Committee will continue to assess progress in coming meetings.”
Minutes from the July 2021 FOMC meeting indicated an emerging consensus among participants to begin tapering later in the year. “Looking ahead, most participants noted that, provided that the economy were to evolve broadly as they anticipated, they judged that it could be appropriate to start reducing the pace of asset purchases this year because they saw the Committee’s ‘substantial further progress’ criterion as satisfied with respect to the price-stability goal and as close to being satisfied with respect to the maximum-employment goal.”
However, other participants preferred to begin the tapering process in 2022. “Several others indicated… that a reduction in the pace of asset purchases was more likely to become appropriate early next year because they saw prevailing conditions in the labor market as not being close to meeting the Committee’s “substantial further progress” standard or because of uncertainty about the degree of progress toward the price-stability goal,” the minutes said.
FOMC members also discussed different speeds of tapering for Treasuries and mortgage-backed securities at the meeting. While “most participants remarked that they saw benefits in reducing the pace of net purchases of Treasury securities and agency MBS proportionally,” others “commented on the benefits that they saw in reducing agency MBS purchases more quickly than Treasury securities purchases, noting that the housing sector was exceptionally strong and did not need either actual or perceived support from the Federal Reserve […]”
In his remarks at the August 2021 Jackson Hole conference, Powell said that he was among the majority at the July meeting: “I was of the view, as were most participants, that if the economy evolved broadly as anticipated, it could be appropriate to start reducing the pace of asset purchases this year.”
Unlike during the 2013 taper tantrum, 5-year and 10-year Treasury yields fell following Powell’s speech, as markets had largely priced in the tapering announcement. In the New York Fed’s July 2021 Survey of Primary Dealers, the median market participant anticipated tapering of both Treasuries and MBS purchases to begin in January 2022.