The Fed is Tapering: What You Need to Know

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The Federal Reserve has finally decided to slow its $85 billion monthly bond-buying program, a long-anticipated and widely discussed move. The central bank said today it will reduce monthly purchases to $75 billion in January because it's seen enough improvement in the economy to begin pulling stimulus. According to today's statements, the program will likely be slowed further in coming months if the economy continues to improve. 

Tapering has been a fear of markets for some time but today's reaction was surprisingly positive on Wall Street. The Dow Jones Industrial Average (DJINDICES: ^DJI  ) is up 1.45% at 3:30 p.m. EST and the Nasdaq Composite, S&P 500, oil futures, and gold have all spiked. 

What tapering really means
There are two things you should take from the Fed's tapering decision. First, the Fed believes the economy is improving quickly enough to slow monetary stimulus, which has helped keep long-term interest rates extremely low. Below I've shown a few of the data points the Fed looks at when making these kind of decisions. As you can see, unemployment is down, GDP growth is picking up, and foreclosures have slowed rapidly over the past three years, all great signs for our economic future.

US Real GDP Growth Chart

U.S. Real GDP Growth data by YCharts.

The Fed needs to slow monetary aid because keeping stimulus going too long risks causing rapid inflation. In that respect, it makes sense to start slowing the program now.

The second thing investors should take away from the decision to taper is that interest rates for everything from mortgages to corporate debt will likely rise over the long term from historically low levels. As you can see below, that's already started to happen, but tapering will slowly take a big buyer out of the market and rates will continue to rise long term as a result.

US 30 Year Mortgage Rate Chart

US 30 Year Mortgage Rate data by YCharts.

What we don't know is how high or how fast interest rates will rise. If the economy doesn't have any setbacks and tapering continues in 2014 the rate rise could happen quickly, but pulling quantitative easing hasn't led to a sharp rise in rates in the past.

This is something to keep an eye one, but definitely not something to panic over; the Fed isn't keen on letting rates rise fast enough to kill a recovery. For the foreseeable future, the rise in interest rates will likely be slow.

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