Following the Federal Reserve

In May, the markets swooned when Federal Reserve Chairman Bernanke suggested it just might be time to think about tapering the Federal Reserve’s quantitative easing bond-buying program. Since then, questions about the Federal Reserve’s timetable have swirled in Washington.

Some, like Wharton finance professor Jeremy Siegel, believe the Federal Reserve should begin to unwind its unprecedented economic stimulus program when the economy reaches 3% annualized GDP growth. Others like Wharton finance professor Krista Schwarz, who once worked on the Federal Reserve’s open market desk in New York, are surprised the Federal Reserve is already talking about the beginning of the end of bond-buying, given unemployment is still at 7.6%.

To add more uncertainty to the equation, the Federal Reserve will have a new leader later this fall. And the frontrunners likely would approach tapering differently. Federal Reserve Vice Chairman Janet Yellen likely would taper slowly, to allow the programs more time to stimulate job growth. On the other hand, former Treasury Secretary Lawrence Summers is thought to favor a quicker withdrawal.

To appreciate the debate over when to taper, it’s important to understand the mammoth nature of the buyback program. The Federal Reserve has been purchasing $85 billion a month in Treasury securities and mortgage-backed securities. The bond buying began in late 2008, when the Federal Reserve had between $700 billion and $800 billion on its balance sheet. To return to a normal market governed by natural forces of supply and demand, the Federal Reserve must stop buying bonds, and then begin selling those accumulated in its inventory. That’s a process Wharton finance professor Joao F. Gomes says may take five to ten years.

Whenever tapering begins, at the end of the line we’ll see an increase in the Fed funds rate and corresponding hikes in short-term interest rates. But, as the experts indicate, it may take years before the Fed funds rate inches back from zero territory to a normal 4%.

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