By Jeffrey Fuhrer
From the beginning of the Covid-19 crisis until November 2021, the Federal Reserve purchased a little more than $4 trillion of Treasury and mortgage-backed securities to stabilize financial markets and stimulate the economy.
Now, as the economy recovers, the need for those large-scale monthly purchases at the same rate diminishes. But slowing the pace presents challenges. In the recovery from the Great Recession, the announcement that the Fed was considering tapering its security purchases sent the markets into a “tantrum” that caused a spike in interest rates in Treasury bonds .
Will history repeat itself?
The Fed began the most recent stimulus in March 2020 to stabilize financial markets that were facing turbulence in the Covid-19 pandemic. With the realization that the shutdowns necessitated by the Covid-19 pandemic would plunge the U.S. economy into a recession, and facing uncertainty about how deep the contraction might be and for how long, key financial markets pulled into their shells, turtle-like, in the spring of 2020.
At first there was a significant decline in both bond yields and in stock market values — the expected response for both in the face of incipient economic turbulence as investors seek the safety and liquidity of Treasuries.
But between March 9 and 18, stresses led to a surprising 0.64 percentage point increase in the 10-year Treasury yield, from 0.54% to 1.18%, even as the stock market continued to fall. This sudden spike in Treasury yields has been attributed in part to large sales of Treasury securities by investors facing immediate liquidity needs (see here ).
In response to the crisis, the Federal Reserve quickly mobilized programs , both tested and novel, to restore financial market function and make sure that the supply of credit continued to flow to businesses. The Fed’s purchase of $1 trillion of Treasury securities by the end of the first quarter of 2020 met the goal of restoring financial market function for the stressed Treasury market.
Cheap borrowing costs
Long after financial markets had stabilized, the Federal Reserve continued with massive purchases of longer-term Treasury securities and U.S. government-insured mortgage-backed securities, which also served the purpose of stimulating the macroeconomy. Purchases of Treasuries and mortgage-backed securities (MBS) are intended to keep longer-term interest rates low, so that businesses that continue to borrow can do so at favorable rates.
When the Fed purchases Treasuries and MBS that are in high demand by private markets, they of course become scarce, leading investors to accept even lower interest rates as inducement to purchase. Those low long-term rates kept the economy from sinking even deeper into recession, preventing greater loss of employment.
For that reason, the rapid buildup of purchases of Treasury and mortgage-backed securities at the onset of the crisis was followed with a continued steady pace of security purchases since the summer of 2020.
The Federal Reserve made the pace of these purchases explicit in December 2020 when it announced that it would be purchasing Treasury and mortgage-backed securities at a pace of $80 billion and $40 billion, respectively, each month. (Prior to that, it had stated that it was purchasing these securities “in the amounts needed to support smooth market functioning” — April 29, 2020 — and “at least at the current pace” from June through November 2020.)
As the economy showed signs of recovery, the Federal Reserve signaled that it would shift toward a gradual reduction in the pace of asset purchases, or “tapering.” While the contraction in economic activity in the spring of 2020 was extremely rapid, so too was the rebound: Just one year after the downturn, real GDP had more than regained its pre-pandemic level.
As is common in downturns, the unemployment rate has taken somewhat longer to recover. But one year after a 10 percentage point rise in unemployment, the jobless rate had recovered smartly, dipping to 4.2 percent in November 2021. The rapid rebound in demand, coupled with some key supply shortages — in labor as well as in key inputs to production — has led to a surge in inflation that is larger than we have seen in 30 years.
In recognition of the recovery in economic conditions, the committee in its Sept. 22, 2021, statement suggested that an “adjustment [in its asset purchases] may soon be warranted.” At its November 2021 meeting, the committee announced that it would slow the pace of purchases to $70 billion and $35 billion per month, respectively, and expects to slow the pace further to $60 billion and $30 billion in December, further tapering purchases by $10 billion and $5 billion, respectively, in each of the ensuing months. This gradual slowing in the pace of purchases is precisely the taper that markets have expected and discussed for some months.