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Published On: Sun, Jan 5th, 2014

Federal Reserve starts taper – and avoids Wall Street Crash

A week or so ago the US Federal Reserve Chairman Ben Bernanke announced that “tapering” would begin. As this is a situation which has not been seen before, opinions varied on what the impact of it would be.

Tapering is a word that came into the economic dictionary in May 2013, when Bernanke told Congress that the Fed may “taper” (reduce) the size of the bond buying program that it was pursuing to stimulate the economy. The program has also been referred to as quantitative easing (QE). The main purpose of the program was to provide an abundance of cash at a cheap price (interest rate) to stimulate business and the financial markets after the economic meltdown.

The program has seemed to work, with gently improving economic figures quarter after quarter. The worry has always been that if the stimulus is reduced or taken away, then the economy could lapse back into recession. Bernanke’s announcement in May was followed by significant turmoil in the markets because of fear of the unknown. However, the markets settled down and the indices have been hitting record highs.

On July 19, Bernanke added to his statement to say that he expected beginning tapering before the end of 2013, with the program ending in 2014. Despite this, many observers expected tapering to start in September 2013, and the fact it didn’t was blamed on weak economic data and the fear of growth being slowed by the oncoming government shutdown and debt ceiling discussion.

So the announcement on December 18 that the program would be reduced from $85 billion per month to $75 billion per month was not foreseen by all parties, although the economy had been steadily strengthening, making this a possibility.

While the markets had reacted to the initial announcement in May, when the time came in December to implement the tapering, it was seen as a positive act and a sign that the economy was recovering well. After all, one of the worst things for financial confidence would be to make a cut and then decide that an increase back up was necessary. The stock market sold off a little on the news, but came back to record a nearly 300 point gain on the Dow, brushing off any fears of disaster.

Stocks are not the only market that is impacted by this action, however. Bonds were also expected to be affected, although the reaction of the bond market showed that the announcement was already more or less priced in. The 10 year Treasury yields had been 2.84%, lifted to 2.92% on the announcement, and then fell back to 2.88%. Analysts say that it might increase to around 3% in 2014, and the Feds smoothed matters by saying that the interest rate will be kept low for a long time, at least until unemployment fell below 6.5%.

When the announcement came, the price of gold dropped noticeably to below $1200 per ounce from its previous level between $1230 and $1240. Gold has been popular since the stimulus program was announced, as it is seen as a hedge against the inflation that could be caused by increasing the money supply and lowering of interest rates. However, by the weekend, the price had steadied above $1200. The price of gold had already gone down in 2013 in expectation of the tapering.

The housing market is seen as a major engine for the recovery, and 30 year mortgage interest rates have risen over 1% since the initial announcement of tapering in May. This is a critical market, and no doubt the Feds will be watching carefully to see that the housing market does not stall.

Bernanke has ceded his Chairmanship after the January meeting, and Vice Chair Janet Yellen has taken over although no big policy changes are expected to the status quo.

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