Fed Tapers $10 Billion, Market Soars

Short-term interest rates to remain near zero, but tightening effect will be felt
December 18, 2013 Updated: December 18, 2013

The Federal Reserve agreed to reduce its stimulus for the U.S. economy for the first time since the 2008 Great Recession, the timing tied to a steadily improving job market.

The shift could lead to higher long-term borrowing rates for individuals and businesses, however, the Fed remains committed to keeping short-term rates at current near zero levels.

“The Committee sees the improvement in economic activity and labor market conditions over that period as consistent with growing underlying strength in the broader economy,” the Fed stated.

The central bank also said after its policy meeting ended Wednesday it will trim its $85 billion a month in bond purchases by $10 billion starting in January. At a news conference afterward, Chairman Ben Bernanke said the Fed expects to make “similar moderate” reductions in its monthly bond purchases if economic improvements continue.

Only 24 of 68 economists surveyed by Bloomberg had expected a taper. The majority of them also got the amount right, having estimated a $10 billion cut.

At the same time, the Fed strengthened its commitment to record-low, short-term rates. It said it plans to hold its key short-term rate near zero “well past” the time when unemployment falls below 6.5 percent. Unemployment is now 7 percent.

This so-called forward guidance helps financial decision makers to plan ahead and thereby reduce risk. In addition, the Fed softened the conditions under which it would taper more.

Dovish Tapering

“The Fed Statement is being viewed as a very dovish tapering—a small reduction in purchases, [the softening of the] unemployment trigger, the unemployment rate trigger now conditional on inflation, no date for end [of easing]. In some ways the key may be the absence of an end-date to tapering,” Citigroup Managing Director Steven Englander wrote in a note to clients.

As a result of this sentiment, markets went up, at record closing highs for the year. The S&P 500 added 1.66 percent, rallying sharply of the day’s lows. The Dow Jones was up 1.84 percent.

The Fed action was approved with a 9–1 vote. Dissenter Eric Rosengren, president of the Federal Reserve Bank of Boston, called the move premature because of high unemployment and low inflation.

However, recently there were more reports showing the economy is accelerating.

Hiring has been robust for four straight months. Unemployment is at a five-year low of 7 percent. Factory output is up. Consumers are spending more at retailers. Auto sales haven’t been better since the recession ended 4.5 years ago.

Effective Rate Hike

Despite the sentiment of dovish tapering, some Fed members have suggested in the past that even a small reduction in the amount of purchases is equal to monetary tightening.

“Financial market reaction to the June and September FOMC meetings provides sharp evidence that changes in the expected pace of asset purchases have conventional monetary policy effects,” James Bullard of the Federal Reserve Bank of St. Louis wrote in September.

Bullard describes the effect in which market participants adjust to the effect of the Fed reducing its activity by reducing their activity, which has a ripple effect through the financial markets.

So despite continued easing flowing into the banking system, the incremental effect of tapering is negative.

The Associated Press contributed to this report.