What "Tapering" Means for Middle America

There's been a lot of commentary lately on the Federal Reserve and the so-called "tapering" of its $85 billion-per-month bond-buying program. But what exactly is tapering? Why don't investors like it, and what does it mean to you and me? Let's cut through the market babble and get down to what tapering really is.

The Fed tries to boost growth
Coming out of the Great Recession, the Federal Reserve pulled virtually every lever available to boost the economy. One of those levers was to "print" money to buy mortgage-backed and other long-term securities in the open market -- a policy known as "quantitative easing." This would put more money in other investors' hands and lower long-term interest rates.

The aim of lowering long-term interest rates is to make it more affordable for people to buy homes and cheaper for companies to offer debt and in turn grow their businesses. A side effect is that stock and bond markets get giddy about the Fed buying everything in sight and push up asset prices.

The economy stands on its own
The inevitable end to quantitative easing means Bernanke & Co. will eventually have to slow bond purchases and let the market get back to normal. There's a lot of debate about when this should be done, but three factors the Fed considers are GDP growth, inflation, and unemployment. As you can see below, GDP and inflation have been steady for three years, while layoffs have now reached a level not seen since 2007.

US Real GDP Growth Chart

US Real GDP Growth data by YCharts.

The economy may not have fully recovered yet, but if the Fed keeps stimulus in place too long, it risks creating the next bubble. So it will gradually take the crutches out from under the economy by slowing, or "tapering," long-term bond purchases, which will allow long-term interest rates to rise. But keep in mind that short-term rates will remain very low, so the Fed is keeping rates low enough to make sure the economy doesn't go into free fall overnight.

What it means to you
As the Fed slowly withdraws its support, how will you be affected? The first impact will be on mortgage rates, and that pain is already being felt. Rates have spiked more than 1% since the beginning of May, and they'll likely rise further once the Fed is no longer buying mortgage assets.

US 30 Year Mortgage Rate Chart

US 30 Year Mortgage Rate data by YCharts.

The other impact will be on the economy and the jobs market. There's fear that if quantitative easing is terminated too early, it could stop the recovery in its tracks and lead us back into a recession. If the Fed is right and the economy can stand on its own, there's no major worry that the jobs market will pull back, but if layoffs begin again it may have to rethink its position.

What it means to your investments
For stocks, quantitative easing is a bit of a conundrum. Traders will tell you that it will suck the air out of the market and stocks will fall if the Fed begins tapering. But long-term investors should keep in mind that the Fed will only taper quantitative easing if the economy can stand on its own.

It's also important to keep in mind that most companies on the Dow Jones Industrial Average (DJINDICES: ^DJI  ) and even the broader S&P 500 (SNPINDEX: ^GSPC  ) have spent the past three years improving their balance sheets. According to the St. Louis Fed, corporate cash levels are now up to $1.78 trillion -- the most on record. Higher interest rates on borrowing money may have some impact on businesses, but GDP growth and consumer confidence will have more. Tapering is by no means an end to the growth in corporate profits or the stock market's gains in the long term.  

Foolish bottom line
Tapering is going to happen; it's just a matter of when. The financial media is making a big deal about it because it's a hot topic, and traders will use it as a reason for short-term moves. But it's actually a sign of strength in the economy, and that's what will help drive stocks higher in the future.

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Read/Post Comments (5) | Recommend This Article (11)

Comments from our Foolish Readers

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  • Report this Comment On August 17, 2013, at 7:38 AM, spankleelee wrote:

    Recovery? It's not a recovery as long as the union busting workforce replacement strategy is in full force. We will not be consuming a whole hell of a lot until we are secure in employment again. Wages get lower, like they have been doing, sales will also get lower. Keep hanging yourselves Wall St! We are waiting for you to crash again very soon.

  • Report this Comment On August 17, 2013, at 8:11 AM, JePonce wrote:

    If you subtract that $85 billion a month from our GDP, then our economic growth is negative.

  • Report this Comment On August 17, 2013, at 12:40 PM, Zanarkand wrote:

    The whole so-called "recovery" is a massive bubble fueled by the Fed's money printing. The Fed can't even talk about tapering without negative effects to the economy. The fact is, this economy cannot survive rising interest rates.

    The rise in home prices and bond prices is fueled by speculative buying. Once interest rates rise to a significant degree, the sell-off begins. The Fed might find they are the only buyer for mortgage securities and bonds.

    With banks so heavily invested in bonds and real estate, once these markets crash, the banks are toast. Queue a repeat of 2007-2008 only worse this time.

  • Report this Comment On August 17, 2013, at 9:31 PM, 2smartforlibs wrote:

    What it means is when the money stops so do the lies about a recovery. This is a fake way to keep the stock market propped up on the backs of your grandkids

  • Report this Comment On August 18, 2013, at 6:28 PM, NovaB wrote:

    This entire program is nothing more than welfare for the banking industry. The American tax payer is NOT getting their money's worth.

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