The Federal Reserve Will Taper, But Don’t Freak Out

(Bloomberg Opinion) -- The U.S. economy is making good progress toward meeting the Federal Reserve's objectives for employment and inflation. This means it's time to revisit a topic that generates great anxiety in financial markets: when and how the Fed will start removing stimulus by reducing its monthly purchases of securities.

Here are my answers to the most pressing questions.

Q. The last time the Fed started tapering, in 2013, it created a lot of turmoil in markets, famously known as the “taper tantrum.” What's different this time around?

A. Back then, Fed officials had little experience with winding down an asset purchase program, no less in an environment where the interest rate on bank reserves, which the central bank started paying only in 2008, was the primary instrument of monetary policy. This left market participants uncertain about the timing and sequencing of the transition to a world with no asset purchases and higher interest rates.

Now, Fed officials have the experience of 2013. And with the exception of the “tantrum,” which occurred in anticipation of tapering, the actual transition went smoothly. So officials are more confident, and market participants have a better sense of the game plan:

Talking about tapering;
Actual tapering;
Raising short-term interest rates from the zero lower bound;
Allowing the gradual run-off the Fed's securities holdings, which should soak up reserves until there's just enough left to satisfy banks' demand.

To be sure, the process won't be on autopilot. Economic and market events might warrant a correction or two. But this time around, at least there's a roadmap.

Q. When will the tapering process start?

A. Assuming that the economic outlook doesn't change much, it's probably about six months away.

First, Fed officials keep saying that the tapering process will begin only after the economy has made “substantial further [my emphasis] progress” toward the central bank's goals of maximum sustainable employment and 2% average inflation. Even with a strong recovery, this will take some time.

Second, the economy is still far from full employment: specifically, about 7.6 million jobs short of where it was prior to the pandemic. Even with gains of 1 million jobs per month, considerably more than the recent pace, achieving “substantial further progress” would take at least several months.

Third, the situation in the labor market is complicated. Despite the big shortfall in employment, job openings are at a record high. It appears that supplemental unemployment benefits of $300 per week, along with the need take care of children when schools are virtual or out of session, are preventing people from taking jobs. What will happen when the benefits expire and students return to classrooms remains an open question.

Q. The Fed is buying $80 billion in Treasury securities and $40 billion in mortgage-backed securities every month. How will the reduction be managed? Will it be proportional, or will one of the two go first?

A. Some Fed officials have made the case for starting with mortgage securities. With home prices rising and the real estate market looking frothy, monetary support seems unnecessary. Sensible as this may sound, I doubt the Fed will go for it. The last tapering cycle established a precedent of reducing Treasury and mortgage-backed purchases in tandem. Any deviation could cast doubt on other aspects of the normalization program.

That said, even if the Fed starts tapering all purchases simultaneously, it can still complete the mortgage-backed part more quickly. If, for example, the central bank cut purchases of both Treasury and mortgage-backed securities by $10 billion per month at each policy-making meeting, mortgage-backed purchases would reach zero after 4 meetings, compared with 8 meetings for Treasuries.

Q. How smooth will the tapering be?

A. That depends on progress towards the Fed's employment and inflation objectives. The aim will be measured, equal steps. But Fed officials will make it clear that the process — to quote from a December 2013 statement — is “not on a preset course” and might change if economic circumstances warrant. That said, any deviation from a “measured pace” would require material and persistent changes in the economic outlook.

Q. Might Fed officials raise the federal funds rate target before the tapering is complete?

A. Very unlikely.

First, buying assets and raising short-term rates would be adding stimulus with one hand and taking it away with the other. This makes no policy sense.

Second, if the economy is doing better than expected and the Fed wants to remove stimulus more quickly, it can simply increase the pace of the taper. This would lead markets to expect interest rates to start rising sooner, too.

Third, the Fed wouldn't want to weaken an important tool of monetary policy. Markets expect interest rates to start rising only after the taper is complete. This perception increases the power of asset purchases in the first place: Market participants know interest rates will stay at zero as long as the Fed is still buying.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley is a Bloomberg Opinion columnist. He is a senior research scholar at Princeton University's Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.