When the Fed Tapers, the Market Will Have a Tantrum
(Bloomberg Opinion) -- At some point, when the U.S. economy looks strong enough, the Federal Reserve will have to scale back its efforts to stimulate growth by buying large quantities of government securities. Announcing such an intention, however, will risk repeating the “taper tantrum” of 2013, when then-Chair Ben Bernanke’s mere suggestion of such a move sent bond yields sharply higher and precipitated big losses for their holders.
Unfortunately, there’s little the Fed can do to prevent another taper tantrum. The best it can do is be prepared and communicate clearly and consistently.
Officials are acutely aware of the danger. Chairman Jerome Powell and Vice Chair Richard Clarida have pushed back against speculation about a tapering of asset purchases later this year. Despite these jawboning efforts, a sharp increase in bond yields is virtually inevitable. Moreover, the longer the Fed waits, the bigger the dislocation will likely turn out to be.
The market mechanics are pretty straightforward. The Fed has pushed down yields by purchasing much of the available supply of Treasuries and agency mortgage-backed securities — so when those purchases end, higher yields will be needed to attract new investors. The central bank has also reduced the near-term risk of investing in the bond market, by indicating that it will step in to squash any rise in yields that undercuts its monetary policy objectives. So as soon as investors sense that the Fed is close to reaching its objectives, they will no longer be comfortable buying bonds at very low yields.
When Fed officials signal that tapering is imminent, they will essentially be saying that the economy will soon have made substantial progress toward their objectives, and that the direction of policy is changing. There’s no easy way to break the news gradually. The shift in regime will necessarily be binary in nature. If the Fed tried to let some air out of the bond market sooner, to avoid a bigger backup in yields later, that would lead to a premature tightening of financial conditions that would make its economic goals harder to reach. Hence the efforts of Powell and Clarida to push back against speculation about the timing of a taper.
These considerations suggest that the tapering of the Fed’s asset purchases isn’t likely to happen this year. Given the raging pandemic and its near-term impact on the economy, the Fed probably won’t make substantial further progress toward its employment and inflation objectives in 2021.
However, later this year, as vaccination helps get the virus under control and the economy rebounds, Fed officials will become more confident that they will need to start tapering in early 2022. As this comes into clearer focus, the Fed’s communication about tapering will necessarily change to foreshadow this shift, and that will generate the inevitable tantrum.
If the increase in yields is large enough to threaten the recovery, the Fed can respond by halting the tapering process or pushing back the date when it plans to start increasing short-term interest rates (or both). As long as it’s prepared to do so, there’s no reason for the tantrum to be unduly damaging. It just will feel bad relative to the quiescent bond market we have experienced since the beginning of the pandemic.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Bill Dudley 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.
©2021 Bloomberg L.P.