Yahoo U: What is tapering?
Yahoo Finance’s Brian Cheung breaks down tapering in this week’s Yahoo U.
JARED BLIKRE: Welcome back to Yahoo Finance Live. I'm Jared Blikre. Well, if you're wondering what a taper is, then you're just like me. And fortunately, we have Yahoo Finance's Brian Cheung here to break it all down for this week's edition of Yahoo U. Brian.
BRIAN CHEUNG: I was going to say, Jared, you know what a taper is. Come on, man. But class is in session. And at one point, the nation's central bank said it wasn't talking about talking about tapering. If you never heard anyone talk about tapering, how would you know what we're talking about when we talk about taper-- wait, what? OK, no. Let me just back up for a second and explain to you exactly what tapering means, how the Fed might do it, and why it's important.
So first off, this is all about the massive amount of assets that the Fed's been buying since the depths of the pandemic. So last year, the Fed moved quick to snatch up trillions of dollars in US treasuries and agency mortgage-backed securities to save the markets from spiraling into a full blown financial crisis. Now, this type of monetary policy, buying assets to add to your balance sheet, is known as quantitative easing, or QE, another Fed-dy term that you may have heard that gets tossed around a lot.
So the question naturally is, OK, well, how much did the Fed buy? The answer is a lot. So the Fed's asset holdings are reflected by its balance sheet, as I mentioned. It was about $4 trillion before the pandemic. And we're now at double that, with the Fed balance sheet having blown through the $8 trillion mark. And the bulk of these purchases, again, were in 2020. You can see the big spike there. But notice how the purchases haven't stopped. It's been kind of steadily increasing. The current pace is about $120 billion a month. And the Fed is still kind of buying these assets. And the question now, of course, is when the Fed will slow or taper the pace of those purchases.
Now, before we get into how the Fed might actually do this, we need to understand why the Fed did it in the first place. So there's robust debate about the impact of QE, but broadly, the Fed's purchases are designed to do these two major things-- first, to ensure market functioning. So the US Treasury markets are the most liquid markets in the world. The Fed wants to make sure that's not going to get out of control. And then mortgage-backed securities in the 2008 crisis was a major deal because the Fed was hoping to backstop losses when the housing market collapsed.
But the other big component of this is just signaling. So we know that the Fed has those interest rates that it can play with, but QE adds an exclamation mark, if you will, and adds to the message to markets that, hey, we're going to keep the easy money going, which they hope are going to give the markets and investors and consumers the confidence to spur economic activity in a downturn.
So, right now, that means that exiting such a policy by tapering could be a pretty big deal. So in the context of this current COVID recovery some Fed official are saying they want to start tapering because they feel the economy has made substantial further progress towards the Fed's two goals on inflation and employment. But the question is how they might do it. So there's some debate about wanting to taper MBS-- again, mortgage-backed securities, which are illustrated here as a section of the balance sheet in orange-- faster than US treasuries, which are illustrated here in blue.
Now the reason why is because the optics of buying mortgage-backed securities into a hot housing market might be bad for the Fed. It's a different crisis than in 2008. It's not like the housing market is collapsing like it was over 10 years ago. So maybe the Fed doesn't like this. And caveat-- I'm going to try to draw it here. This might not look very good. But let's say, for example, they try to stop the agency mortgage-backed securities first. That might mean that it might plateau very soon, whenever they decide to start tapering.
But the US Treasury purchases could continue to be in-- or rather, they could continue to buy more US treasuries, but at a slower rate, and then kind of plateau at a later point. And then the total balance sheet might look something very similar to that. It would kind of increase, but at a slower rate, and then ultimately plateau. Now these lines aren't that bad, but the idea here is notice how it's not shrinking the balance sheet. These lines aren't going down when they start to taper. Again, it's just slowing the pace of its growth, which is a big reason why a lot of Fed officials say even when the taper begins, monetary policy will still be supportive of the economy.
Now, tapering is a big deal because it's all about timing. So out of the 2008 financial crisis, then Fed Chairman Ben Bernanke spooked markets by letting it slip that a taper could be coming in congressional hearing. And that had bond yields moving crazy on the news. They didn't expect that to happen at all. But then there's the other side of the coin. If you taper too late-- and this is an opinion that's been voiced by some Fed officials right now-- they worry that continuing to buy assets into this type of market could inflate an asset bubble that could blow up and end up creating-- guess what-- maybe a new mess.
So it's really all about getting it right. And that's why this is such a hot topic, guys, and why people are always talking about taper this and taper that. And that's why if you think about this being a spicy topic, just imagine how spicy of a topic it's going to be when the Fed, at some point down the line, maybe tries to unwind its holdings, which was a very hot debate in the years leading up to the COVID pandemic. But of course, when it comes to unwinding the balance sheet, that's a conversation we'll leave for another episode of Yahoo U. But for now, guys, class is dismissed.
JARED BLIKRE: [CHUCKLES] I'll tell you what. You know, based on your last remarks there, I'm wondering if that's actually going to happen. Brian, while we have you here, I want to dial back to maybe 2013, '14. It was one of Bernanke's not last press conferences, but this had to do with the fact that the Fed was thinking about winding down its balance sheet.
And it's pretty interesting that you just said that, because at the time, there was a concern that the Fed could actually lose so much money because the bond prices had shifted from their purchase prices that they would go cash flow negative. They returned their profits to the Treasury, I believe, every week or every month. And that process could halt for a while.
So now that their balance sheet is literally a multiple of that, I'm just thinking and wondering, well, if interest rates do launch from here and do rise, is that another possibility? I think it's something that maybe Lael Brainard may have to address-- excuse me-- in a few years here.
BRIAN CHEUNG: Yeah, absolutely, Jared. And I think that one important point that you bring up is that when you unwind the balance sheet, there's one way you could do it, which would be selling into the open market. And as you suggested, if bond prices are radically different than they were when you bought them, then maybe you do take a loss.
But the other way that you could allow these assets to, effectively, get off the balance sheet is to let them roll off and mature. Because you have to keep in mind that agency mortgage-backed securities and the US treasuries that the Fed buys of various duration do have maturity dates where, ultimately, they just roll off the balance sheet.
So there's a lot of advocacy when the Fed was trying to start tapering, which you mentioned Ben Bernanke had been talking about it in 2014. But ultimately, the Fed didn't even try to do something like that until many years after that. And even then, the process was stopped when the US-China trade war really blew up under the Trump administration.
So the Fed has really never in practice really had much experience in doing this type of thing. But it does remind me-- you bring up Ben Bernanke, Jared-- a beautiful quote that we got from the former Fed chairman at one point who said, QE, it works in practice, but not in theory, something kind of, I think, is very funny and kind of, actually, quite true.
AKIKO FUJITA: You called that a beautiful quote, Brian. Only you and Jared. But now that we have a lesson in tapering--
BRIAN CHEUNG: [INAUDIBLE]
JARED BLIKRE: Now that we have a lesson in tapering, we can put our Fed knowledge to use because Brian, of course, is going to be out at Jackson Hole for the symposium all next week. We're going to have live coverage out of Jackson Hole. And of course, we've got a long list of guests lined up. Brian is going to be out there live for us, August 26 and 27. You certainly don't want to miss that coverage. Our thanks to Brian as well for today's lesson.