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Spotlight on Economics: Federal Reserve ""Tapering""

The Fed began tapering at its December 2013 meeting by reducing monthly bond purchases by $10 billion (equally split between treasury securities and MBS).

By Robert Herren, Professor

NDSU Agribusiness and Applied Economics Department

Since 1789, people in the U.S. have debated fiscal policy (government expenditures and taxation) and monetary policy. Political debates in recent years have focused on fiscal policy issues concerning ""fiscal cliff,"" “sequestration"" and the national debt limit.

However, academic economists and participants in financial markets continue to debate current monetary policy. Indeed, a colleague recently forwarded me information from an agricultural producer group that indicated concern that the Federal Reserve's recent monetary policy will result in a large increase in inflation.

During the past three decades, most central banks have targeted a short-term nominal interest rate (federal funds rate in the U.S.) as their primary monetary policy tool. During the fall of 2008, the Federal Reserve (Fed) established a target of between zero and .25 percent for the federal funds rate and has not changed the target since then.

Without the ability to lower further the federal funds rate, the Fed has been forced to adopt unconventional methods in its efforts to stimulate the economy. Generally, these methods attempt to expand the monetary base (currency and bank reserves) and lower long-term interest rates, especially mortgage rates. Most economists believe that long-term real (inflation-adjusted) interest rates affect aggregate demand for currently produced goods and services.

Most writers use the term quantitative easing (QE) to describe the unconventional tools in which the Fed has expanded the monetary base, in part, by buying longer-term treasury securities (bonds) and federal agency mortgage-backed securities (MBS), in addition to its traditional purchases of short-term treasury securities. The third round of QE, which began in September 2012, involved a monthly purchase of $45 billion of treasury securities and $40 billion of MBS.

During early summer 2013, many market participants interpreted comments by several Fed policymakers, including chairman Ben Bernanke, to indicate the Fed soon would begin to reduce (taper) these monthly bond purchases. Within one month, longer-term interest rates increased by almost 1 percent and Fed officials frantically worked to clarify their plans in hopes of preventing further increases in interest rates.

The Fed finally began tapering at its December 2013 meeting by reducing monthly bond purchases by $10 billion (equally split between treasury securities and MBS). The Fed continued this tapering at its next four meetings, so that its monthly bond purchases in July were $35 billion. The financial markets did not panic after tapering began. Indeed, interest rates on 10-year and 30-year treasuries were lower on July 1, 2014, than on Aug. 1, 2013.

Although the ride through ""tapering"" has been relatively smooth for the financial markets, the road may be bumpier when the Fed undertakes other actions to return to a longer-term ""normal"" monetary policy. The Fed will raise its target for the federal funds rate. Its stated goal is to ultimately reduce its asset portfolio from the current level exceeding $4 trillion to the precrisis level of approximately $900 billion.

This quantitative contraction by the Fed will be even more controversial and potentially more turbulent for the nation’s economy and its financial markets than the preceding tapering of quantitative easing.

NDSU Agriculture Communication – Aug. 12, 2014

Source:Robert Herren, (701) 231-7698, robert.herren@ndsu.edu
Editor:Rich Mattern, (701) 231-6136, richard.mattern@ndsu.edu
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