The Fed’s Plans To Taper Asset Purchases: Good Or Bad News?

Investor fears that the Federal Reserve will begin shrinking, or “tapering,” its asset purchase plan over the coming months came true this Thursday after Ben Bernanke, chairman of the country’s central bank, announced that the Fed will start going easy on its $85 billion a month asset purchase program by the end of the year and will most likely wind up the program by mid-2014. ^[1]

The decision comes after a notable improvement in economic indicators like unemployment rates and house price index witnessed over last several months, highlights that the U.S. economy is well on its path to recovery – negating the need for additional stimulus from the Fed. The Fed does, however, intend to keep interest rates at the current all-time-low levels of between 0-0.25% for some more time. ^[2]

Concerns about an announcement by the Fed along these lines kept equity markets across the globe in flux for well over a fortnight now with share prices across sectors fluctuating considerably over the period. The implication that a reduction in asset purchases by the Fed will lower liquidity in the U.S. economy and consequently slow the economic recovery combined with uncertainty over the Fed’s next steps is responsible for the volatile market conditions. Though markets bore the full brunt of investor sentiments, shares of investment banks were hit quite hard in particular with Goldman Sachs (NYSE:GS) showing the biggest decline in value followed by Morgan Stanley (NYSE:MS) with a 4% fall in prices apiece.

But is the Fed’s decision to pull the plugs on the asset purchase plan really bad news?

We are inclined to think that maybe this is not the case. There are several things going right here. Firstly, the country’s macroeconomic indicators have indeed improved quite a bit since the swoon caused by the economic downturn of 2008 and the ensuing debt crisis in Europe. So the situation is much better than it was in early 2012, and the outlook is pretty good too. Secondly, the Fed isn’t ending the stimulus abruptly. Going from $85 billion a month in asset purchases in June to zilch in July would have been akin to slamming on the car brakes after it has just gained decent momentum. The fact that the stimulus package will be withdrawn gradually by mid-2014, gives the economy time to adjust to the changing situation.

While it is no doubt possible to argue the merits and demerits of the Fed’s plans back and forth, we leave you with something to think about. In which of the scenarios do you think the country’s economy would be better off in the long run: one in which it continues to use the Fed’s repurchase plan as a crutch for the foreseeable future potentially leading to the misallocation of capital with artificially low interest rates that also raises the risk of higher inflation and a weaker dollar in the long run, or one in which the economy staggers a bit bringing with it higher volatility in the near term as the crutch is cautiously removed so that the real economy can find its footing on its own?

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1. Federal Reserve Press Conference Transcript, Federal Reserve Website, Jun 19 2013 [↩]
2. Federal Reserve Board and Federal Open Market Committee release economic projections from the June 18-19 FOMC meeting, Federal Reserve Website, Jun 19 2013 [↩]