Fed begins reducing bond purchases: What happens next?

A statue of George Washington stands outside a building

The Federal Reserve announced a reduction of quantitative easing this month. And that should be a positive sign for the economy.

Luis Alvarado, Investment Strategy Analyst, Wells Fargo Investment Institute
Luis Alvarado, Investment Strategy Analyst,
Wells Fargo Investment Institute

When I was a kid growing up in Costa Rica, I often heard about “the crisis”—the severe recession that hit the country in the early 1980s—though I didn’t necessarily understand the problems it caused until much later. After all, what kid can appreciate the devastating impact of an inflation rate near 100%, a doubling of unemployment, or a 9.1% contraction of GDP? As an adult—and as an analyst with Wells Fargo Investment Institute—now it’s easier to understand the consequences of such a serious economic crisis.

Those potential consequences are why the U.S. government moved swiftly to combat the recession triggered by the coronavirus pandemic in early 2020. Among the tools the government employed: quantitative easing, where the Federal Reserve (Fed) started purchasing U.S. Treasury securities and mortgage-backed securities to pump more money into the economy to keep long-term interest rates down and make it easier to borrow. Since July 2020, the Fed has been buying $120 billion of these securities every month, the idea being that it would continue to do so until “substantial progress” had been made toward its inflation and employment objectives.

From easing to tapering

The big news is that we’re now at that point. The actions taken to support the economy through the coronavirus pandemic have proven effective. Though some challenges remain, the economy is proving to be robust. And now, all the money that the Fed is pumping into the economy coupled with the supply-chain disruptions is playing a role in pushing up the rate of inflation, which is currently more than double what it was before the pandemic. These are signals that it’s time for easing to end.

Obviously, the Fed agrees: At its November 3 meeting, it announced that it would begin reducing quantitative easing by $15 billion each month. If all goes well, the Fed will no longer be buying bonds by June 2022. This is what is known as “tapering”.

What happens next?

At Wells Fargo Investment Institute, we believe that interest rates are likely to move higher, but not like the sharp spike we saw the last time the Fed announced the tapering of a quantitative easing program back in 2013. The market today better understands tapering: It’s a gradual reduction in monetary accommodation, but it’s not tightening, i.e. when the Fed raises short-term interest rates through an increase in the fed funds rate to signal that it wants to put the brakes on economic growth. We do not anticipate that the federal funds rate target will increase until tapering ends. This clear path forward for tapering may help the economy steer clear of stagflation—a time of slow economic growth and high inflation.

And what does this mean for investors? In equity markets, some sectors will likely benefit from higher interest rates. These sectors may include financials, industrials and communication services all in which we have a favorable guidance. And bond portfolio strategy will be increasingly important as long-term bonds may be more volatile. My Wells Fargo Investment Institute colleagues Peter Wilson, Global Investment Strategist; Brian Rehling, CFA and Senior Global Investment Strategist; and I explore this topic and share our expectations around bond yields in the Institute Alert “Fed announces tapering of bond purchases.” Of course, your ideal mix of stocks and bonds—or any adjustments you may decide to make when tapering ends—depends on your long-term goals.

Wells Fargo Investment Institute, Inc., is a registered investment adviser and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.