Economic Forecasts

Interest Rates and the Fed’s Taper

What happens in January could set the tone for long-term rates for the rest of the year.

With the long-awaited “tapering” of the Federal Reserve’s bond-buying here, the question is, what does it mean for long-term interest rates? How much and how fast they rise depends on whether investors take up the slack. If other bond buyers step up to the plate in January, then rate increases will be small over the course of the next year. If not, investor anxiety will push up rates faster. Short-term rates will not be affected until late in 2015, when the economy is likely to be strong enough and unemployment, low enough for the Fed to hike the federal funds rate.

Outgoing Federal Reserve Chairman Ben Bernanke made it official that the central bank will start trimming its bond purchases in January. Though he announced only a first $10-billion reduction in the Fed’s $85 billion-a-month purchases of long-term securities, he implied that further cuts would be forthcoming at regular intervals if all goes according to plan. He also, of course, reserved the right to delay cuts if it doesn’t.

The impact on interest rates is likely to be a gradual rise in long-term rates, pushing them to somewhere between 3.3% and 3.6% at the end of 2014. Here’s why:

The timing of the wind-down is ruled to a significant degree by when the policy-setting Federal Open Market Committee meets, because its members vote on whether to cut purchases and by how much. At any time, the FOMC could elect to accelerate, decelerate or even suspend the planned reductions in bond purchases, depending on how the economy -- in particular, inflation and unemployment -- are developing.

There are eight scheduled meetings in 2014. If the committee decides at each meeting to systematically cut its buying by $10 billion monthly, with a final $5 billion purchase, it would wrap up quantitative easing by the end of 2014. Between now and then, the Fed would still buy $460 billion or more of long-term securities, pushing its balance sheet of securities, loans and other assets to $4.5 trillion by the time the program ends.

If interest rates rise by about 0.1 percentage point every time the Fed cuts, the 10-year Treasury bond will end 2014 at just above 3.6%. That’s how much rates rose in the 24 hours immediately following the Fed’s announcement that it would start tapering. It’s reasonable to assume that rates could continue to climb that much with each reduction in the amount of monthly quantitative easing, if investors in Treasuries remain nervous that demand for long-term securities will fall as the Fed exits.

January could set the tone for interest rates for the rest of the year. If, however, investors see other bond buyers step up to the plate in January and each time thereafter, replacing Fed purchases to hold demand steady, nervousness will be muted. Long-term rates would likely climb by only about half that amount with each Fed meeting, and they’d wind up at about 3.3% at the end of 2014.

Step 4

Fed policymakers could speed up the process, of course, cutting by increments greater than $10 billion each month. One reason for doing so is the ballooning size of the Fed’s portfolio. It makes markets uneasy to see the Fed holding such an enormous quantity of long-term securities, and some Fed officials fear that the size of the portfolio creates another policy dilemma: how the Fed can divest itself without roiling markets. Reducing quantitative easing faster also appeals to those who favor injecting less stimulus into the economy and allowing it to stand on its own feet sooner. Ditto, those who worry the Fed’s huge purchases potentially contain seeds of a longer-term problem with inflation.

Conversely, the Fed could temporarily suspend or skip an opportunity at one or more FOMC meetings to trim bond buying if recovery falters or interest rates rise too quickly. But a pace of about a $10-billion reduction for each FOMC meeting is the most likely.

Note that the financial markets reacted in diverse ways to the Fed’s announcement. The stock market rallied, heartened that the Fed judged the economy to be making progress, while, predictably, long-term bond prices fell and rates rose. Short-term rates, however, were virtually unchanged and will likely remain so for some time. Bernanke’s reaffirmation of the Fed’s patience plus the publicly announced views of FOMC members both point to a date in late 2015 as the most likely time for the Fed to hike the federal funds rate. It’ll take until then for the jobless rate to fall well below 6.5%, the Fed’s previously announced threshold for possible action.

Five years ago, a raging financial crisis was pulling well-known Wall Street firms into the ashes and devastating lives on Main Street as jobs disappeared and homes were foreclosed. The start of the Fed’s tapering can be seen as a historic step away from an extraordinary period of monetary stimulus.

Most Popular

The 15 Best Growth Stocks for the Rest of 2022
growth stocks

The 15 Best Growth Stocks for the Rest of 2022

A sharp selloff in growth stocks this year creates opportunity for keen investors. Here are 15 top-rated picks to consider in the second half of 2022.
June 28, 2022
Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
Best Internet Banks
online banking

Best Internet Banks

These institutions operate fully online, which decreases their overhead costs and allows them to offer lower fees and higher rates than many other ban…
June 23, 2022

Recommended

Kiplinger's Economic Outlooks
Economic Forecasts

Kiplinger's Economic Outlooks

Regularly updated insights on the economy’s next moves.
July 1, 2022
Most-Overlooked Tax Deductions and Credits for the Self-Employed
Tax Breaks

Most-Overlooked Tax Deductions and Credits for the Self-Employed

If you've recently gone into business for yourself, don't miss these tax breaks for the self-employed.
June 11, 2022
Is a Recession Coming?
Smart Buying

Is a Recession Coming?

With a lot of recession talk out there, we might just talk ourselves into one. We take that risk with Jim Patterson of The Kiplinger Letter. Also, dol…
May 31, 2022
25 Best College Majors for a Lucrative Career
college

25 Best College Majors for a Lucrative Career

One way to increase your chances of earning a good living is to pick a college major that prepares you to work in a field that pays well. Here are som…
May 31, 2022