Fed Announces Bond Tapering — How Does It Impact Interest Rates?

Mandatory Credit: Photo by Sarah Silbiger/AP/Shutterstock (12550104a)Federal Reserve Chairman Jerome Powell testifies during a House Financial Services Committee hearing on Capitol Hill in Washington.
Sarah Silbiger/AP/Shutterstock / Sarah Silbiger/AP/Shutterstock

The Federal Reserve announced yesterday it will begin tapering its bond purchases later this month, a first step in reining in historically accommodative monetary aid during the coronavirus pandemic.

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In a post-meeting statement, the Federal Open Market Committee stated “beginning later this month, the Committee will increase its holdings of Treasury securities by at least $70 billion per month and of agency mortgage-backed securities by at least $35 billion per month.”

Beginning in December, the Committee will increase its holdings of Treasury securities by at least $60 billion per month.

The committee said the move came in light of “the substantial further progress the economy has made toward the Committee’s goals since last December.” Some of these goals included maximum employment and inflation near or at 2%.

The Fed has two main tools at its disposal to influence market conditions, the first of which is to directly increase or lower interest rates. Although the quicker of the two, this option is also more sudden and causes blunt effects to the economy in a short amount of time. The second is Open Market Operations, by which the Fed either increases or reduces the amount of Treasury bonds it purchases.

If the Fed buys bonds in the open market, it effectively increases the amount of money in the economy by exchanging bonds for cash to the general public. Buying bonds, which has been its policy for quite some time now, especially during the pandemic, injects cash into the economy, making money easier to both obtain and receive a loan for. Prices are typically pushed higher when the Fed buys bonds and interest rates decrease. When the Fed sells bonds, the hope is that prices go down and interest rates increase.

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The Committee stated several reasons for its decision, pointing to improving economic and labor market conditions. Their statement noted that “with progress on vaccinations and strong policy support, indicators of economic activity and employment have continued to strengthen.”

They added that the sectors most adversely affected by the pandemic have improved in recent months, but that a surge of COVID-19 infections during the summer months slowed progress. The committee also acknowledged that inflation is elevated, but maintained their stance that they believe it to be transitory. They state that supply and demand imbalances related to the pandemic and the reopening of the economy have contributed to sizable price increases in some sectors.

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Inflation is up almost 6% for the year, and Wall Street overwhelmingly disagrees that the effects of inflation are temporary. The Treasury yield curve inverted last Thursday, indicating expectations from investors that a rate hike is on its way sooner than previously expected.

The data from the committee also stated  that “the path of the economy continues to depend on the course of the virus … risks to the economic outlook remain.”

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