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You are here: Law & Politics Economics Effect of Federal Reserve’s Tapering Still Uncertain
As the markets enter the final month of fiscal Q1 2014, the impact of the U.S. Federal Reserve’s move to taper or reduce its monthly purchase of bonds via the Quantitative Easing program has been a mixed bag. That’s not exactly what forecasters expected.

Interest rates did not skyrocket in Dec. 2013 as previously speculated when the Federal Open Market Committee – the Federal Reserve’s monetary policymaking body – announced it would go forward with the first $10 billion tapering of QE bringing its then monthly purchases of U.S. Treasury bonds down to $75 billion for Jan. 2014. Interest rates didn’t jump either in late January 2014 when the FOMC again decided to cut its purchasing by another $10 billion for Feb. – essentially shaving off a quarter of the program in less than two months. 
That’s the pretty picture; the one that is in focus.

In the other picture that is still developing, Wall Street is awfully unpredictable when it comes to its reaction to QE cuts.

During early trading on Jan. 29 – the day the FOMC made an afternoon announcement of continued cuts – the Dow Jones Industrial average fell just short of 134 point. Even though that is close to only one percent of its entire trading, it is still significant. Compare that downward reaction to what happened on Dec. 18 when the first taper was announced. By the close of trading at 4 p.m. that day, the Dow was up just shy of 293 points or about 1.5 percent.  That positive outcome – labeled an embrace of the taper by CNN Money – was not what forecasters expected. In mid-May 2013 when then Fed chair Ben S. Bernanke announced the FOMC was “considering” the beginning of a taper, the market had the equivalent of financial toddler tantrum. With a couple short weeks as uncertainty increased, the Dow dropped below 15,000 – a mentally significant number to Wall Street professionals – and remained there often throughout the summer posting several multi-day losing streaks. By the end of May 2013, 30-year mortgage rates climbed 17 basis points.

“What struck me when Bernanke first announced the Fed was considering taper was the immediate reaction in the markets. Big jump interest rates by a full percentage point in two weeks. Yet nothing had been done yet,” commented Dean Baker, co-director at the Center for Economic and Policy Research in Washington, D.C. “When the Fed actually did say in December that it would begin the first taper, nothing happened.”

Baker suspects the panic beginning in May and last throughout the summer could be more attributed to human behavior rather than economic conditions.
“When people began to anticipate the taper is when they actually reacted,” he noted. “When the taper began, there really wasn’t much of a reaction. Perhaps between May and December, everyone was used to the idea.”

This latest round of QE, which began in Sept. 2012, is dubbed QE3. However, it isn’t the third time the Fed has taken significant action to bolster the U.S. economy. The first action – called “Operation Twist” in honor of the dance fad of the era – came about in 1961. At that time, the Fed exercised open market option to sell short-term public debt and reinvest it in longer options. In 1979, the “Saturday Night Special” increased the federal fund rate on overnight borrowings between banks and other entities to maintain their bank reserves at the Federal Reserve by a full percentage rate over the first weekend in October. It caused some U.S. Treasury bonds to be defaulted and the Dow dropped 64 points in two days. QE1 between Dec. 2008 and March 2010 started with a plan of purchasing $600 billion in government agency mortgage-backed securities. It ended with the Fed owning more than $2.1 trillion. Under QE2, the Fed used a different approach purchasing $600 billion of long-term U.S. Treasury products between Nov. 2010 and June 2011. Three months later in Sept. 2011, the Fed revamped the 1961 Operation Twist with its $400 billion purchase of bonds with maturity dates from six to 30 years while selling off all bonds with maturity dates less than three years as had occurred 40 years previously. It was indeed a twist – the original maneuver in 1961 was believed to have not met its objective. The Fed revived “twist” after one of its economist based in San Francisco – Eric Swanson – reexamined the original plan recommending another go-around with a few tweaks including the maturity dates. Enter QE3, which began Sept. 2012, and the Fed’s plan to exit this market-bolstering strategy.
To Baker, all the discussion of the effects of this latest round of QE might be a big hurray over little impact. For instance, QE3 most likely kept 30-year mortgage rates from making an additional half-percentage point increase, he believes. That does not create a huge boom in new home purchases, but it does give existing homeowners some leeway to refinance and free up some cash for other purchasing or debt service.

“People are exaggerating on the positive and the negative,” said Baker.

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