How the Fed's taper affects interest rates

What happens in January could set the tone for long-term rates for the rest of the year.

By MSN Money producer Dec 27, 2013 9:24AM

By Glenn Somerville and David Payne, Kiplinger'sKiplinger's


With the long-awaited "tapering" of the Federal Reserve's bond-buying here, the question is, what does it mean for long-term interest rates?


Image: Federal Reserve Building (© Hisham Ibrahim/Corbis)

How much and how fast they rise depends on whether investors take up the slack. If other bond buyers step up to the plate in January, then rate increases will be small over the course of the next year. If not, investor anxiety will push up rates faster. Short-term rates will not be affected until late in 2015, when the economy is likely to be strong enough and unemployment, low enough for the Fed to hike the federal funds rate.

 

Outgoing Federal Reserve Chairman Ben Bernanke made it official that the central bank will start trimming its bond purchases in January. Though he announced only a first $10-billion reduction in the Fed's $85 billion-a-month purchases of long-term securities, he implied that further cuts would be forthcoming at regular intervals if all goes according to plan. He also, of course, reserved the right to delay cuts if it doesn't.

 

The impact on interest rates is likely to be a gradual rise in long-term rates, pushing them to somewhere between 3.3 percent and 3.6 percent at the end of 2014. Here's why:


 

 

The timing of the wind-down is ruled to a significant degree by when the policy-setting Federal Open Market Committee meets, because its members vote on whether to cut purchases and by how much. At any time, the FOMC could elect to accelerate, decelerate or even suspend the planned reductions in bond purchases, depending on how the economy -- in particular, inflation and unemployment -- are developing.

 

There are eight scheduled meetings in 2014. If the committee decides at each meeting to systematically cut its buying by $10 billion monthly, with a final $5 billion purchase, it would wrap up quantitative easing by the end of 2014. Between now and then, the Fed would still buy $460 billion or more of long-term securities, pushing its balance sheet of securities, loans and other assets to $4.5 trillion by the time the program ends.

 

If interest rates rise by about 0.1 percentage point every time the Fed cuts, the 10-year Treasury bond will end 2014 at just above 3.6 percent. That's how much rates rose in the 24 hours immediately following the Fed's announcement that it would start tapering. It's reasonable to assume that rates could continue to climb that much with each reduction in the amount of monthly quantitative easing, if investors in Treasuries remain nervous that demand for long-term securities will fall as the Fed exits.

 

January could set the tone for interest rates for the rest of the year. If, however, investors see other bond buyers step up to the plate in January and each time thereafter, replacing Fed purchases to hold demand steady, nervousness will be muted. Long-term rates would likely climb by only about half that amount with each Fed meeting, and they'd wind up at about 3.3 percent at the end of 2014.


Fed policymakers could speed up the process, of course, cutting by increments greater than $10 billion each month. One reason for doing so is the ballooning size of the Fed's portfolio. It makes markets uneasy to see the Fed holding such an enormous quantity of long-term securities, and some Fed officials fear that the size of the portfolio creates another policy dilemma: how the Fed can divest itself without roiling markets. Reducing quantitative easing faster also appeals to those who favor injecting less stimulus into the economy and allowing it to stand on its own feet sooner. Ditto, those who worry the Fed's huge purchases potentially contain seeds of a longer-term problem with inflation.

 

Conversely, the Fed could temporarily suspend or skip an opportunity at one or more FOMC meetings to trim bond buying if recovery falters or interest rates rise too quickly. But a pace of about a $10-billion reduction for each FOMC meeting is the most likely.

 

Note that the financial markets reacted in diverse ways to the Fed's announcement. The stock market rallied, heartened that the Fed judged the economy to be making progress, while, predictably, long-term bond prices fell and rates rose. Short-term rates, however, were virtually unchanged and will likely remain so for some time. Bernanke's reaffirmation of the Fed's patience plus the publicly announced views of FOMC members both point to a date in late 2015 as the most likely time for the Fed to hike the federal funds rate. It'll take until then for the jobless rate to fall well below 6.5 percent, the Fed's previously announced threshold for possible action.

 

Five years ago, a raging financial crisis was pulling well-known Wall Street firms into the ashes and devastating lives on Main Street as jobs disappeared and homes were foreclosed. The start of the Fed's tapering can be seen as a historic step away from an extraordinary period of monetary stimulus.  

More from Kiplinger's:

13Comments
Dec 27, 2013 12:52PM
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Of note... the Dow broke FIFTY record highs in 2013 without one single solitary family-sustaining wage or salary job recovered. Not ONE of the 90 million under and unemployed Americans went back to their career field and pay. To be 24 years old this year, means you never worked in an up economy or a stable position. In nations that don't eliminate long-term unemployed from the data, youth exceed 40% of the unemployed and the number of long-term under and unemployed are consistent vs. the whole population with our own.
The top 5% wealthy earners took 100% of the Quantitative Easing (QE) monies and hoarded them. Being rich today means having a Bulls Eye tattoo'd on your forehead AND you are putting your own bloodlines at risk. Is it really worth it? Cash today, no life tomorrow? If you were TRULY talented... you'd know how to balance this and still keep your maniacal dream of wealth. Too bad you aren't talented, just corrupt. 
Dec 27, 2013 12:08PM
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Interest Rates-- few people ever consider the cost of credit and apparently, Ben Bernanke was one of them. There are $700 TRILLION in derivatives outstanding and the sheer cost to service all those worthless assets generated by banks will add astronomical to unbelievable. Every home mortgage made this century is toxic. In 2014, we should start hearing about servicing LOSSES. When it costs more to service than the interest generated-- you take a loss. Those losses won't be absorbed by banks because they aren't solvent now. The term: Bail In is already afoot. A Bail-In is when a bank must take from your accounts to accommodate they're lack of funds. 
The cost of higher rates also translates to garbage business platforms. Now richer than ever but it isn't kept on our continent, global discourse will sever accessibility. They will then- borrow at higher rates and immediately translate that into retail prices increases and attempt to force us to pay. Most of the nation is destitute, not living in poverty-- destitute. The cupboards are bare and inflation compromises the nation.
2014 is an election year. Every voter will be watching to see who blockades, stalls, filibusters or leverages adverse groups like lobbies, parties and religious entities to make cold war and who generates commonsense. Higher rates are good when institutions are run with the country, not opposed to it and funding wealth-terrorism. 
The posters on here before me-- Brent, Taxpayer 1 and Fat Cat are prime examples of who you don't want to be in 2014. You can't legitimize greed, you can only be taken out because of it. We the People aren't rich but we are alive, greed is rich but won't outlive what they've done to us. I'd choose life before dying for fiat money. 
Dec 27, 2013 5:00PM
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Try interest rates at the end of 2014 at  5.3 % !   So much for the recovery ! Housing will tank ,loans will dry up for the middle class and unemployment will hit 20 %. So much for the central bank planners these guys are GENIUS !  They all studied economics at Harvard , Princeton and Yale !
Dec 27, 2013 5:15PM
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Flat to a bit down, not a bad way to end a very good week, manipulators did not go home pleased for the weekend, hey, Monday they will be here ready to cheat their behinds off.....Have a great weekend all.
Dec 27, 2013 4:21PM
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We've been trying to keep things flat, entering the last 40 minutes we see our buddies trying to bring us down; not hard to understand after the last few weeks, scumbags are supper peed off, on steroids we guess....Oh well, we will see what happens these last few minutes....More after the close.
Dec 27, 2013 12:01PM
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Yes, we've had a nice week and a nice month and yes, we were up over 40 points on the Dow this morning and many people thought it would be another great morning but, a couple of things, the volume is still very low and you can imagine the mood these manipulators are in....Comical actually; at 1030 hrs they started to do their thing though so as you may have noticed, we are all in the red...Still 5 long hours to go though, anything can happen....Dow over 16K, imagine is we had a real President, like Romney, the Dow would be at about 18K plus...Remember, the President doesn't have anything to do with the day to day markets but, at election time the market reacts instinctively....When this inept buffoon got reelected we lost over 1500 points, thus the difference if Romney were the man....More later.
Dec 27, 2013 11:05AM
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Bernanke and Obama`s policies have minted lots of millionaires the last few years.I`m one

of them.People with brains are far better off than 5 years ago.One of the many reasons I love

America.

Dec 27, 2013 12:36PM
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Millionaires regularly post on these blogs - Thumbs Up
Millionaires have other things to do - Thumbs down
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