The U.S. Fed Tapering Has Started – Now What?

A breakdown of the U.S. Fed Tapering.

The U.S. Federal Reserve is lifting its proverbial foot off the stimulus gas pedal. Also known as quantitative easing, the Fed started the program 15 months ago in an effort to kick-start the U.S. economy, which was still struggling from the 2008 financial crisis. To do so, the government bought back mass quantities of its own bonds – a measure that keeps yields low (and boosts the perception of investor security), and the cost of borrowing low for consumers. It also pumped $85 billion back into the economy each month.

Now, beginning in January, it will reduce its bond buying by $10 billion a month, essentially taking that much liquidity out of the U.S. economy.

The U.S. Fed tapering announcement made this week was a surprise to the experts but has been well received by investors, who sent stocks higher after learning of the Fed’s plans. This signals that economic conditions are slightly better than they have been for five years, but there are still many years of recovery ahead.  Here’s what the Fed is purposing and what it could mean to Canada’s economy.

Breaking Down The Fed’s Move

Fed Chairman Ben Bernanke said they’re reducing their asset buying in two areas. In a prepared statement the Fed states “beginning in January, the committee will add to its holdings of agency mortgage-backed securities at a pace of $35 billion per month rather than $40 billion per month, and will add to its holdings of longer-term treasury securities at a pace of $40 billion per month rather than $45 billion per month.”  In plain english – this means the U.S. will be buying fewer mortgages. This could also result in U.S. homeowners being faced with higher fixed mortgage rates. Banks will look for ways to profit as they will no longer be able to borrow at rock bottom rates.

Central Bank Rates Will Remain Low

To offset the move to scale back stimulus the Fed also said interest rates will remain low for the long term.  The Central bank knows that rising rates in tandem with reducing stimulus would be catastrophic for the U.S. economy. The recovery has been tepid at best and this first move towards normal conditions comes after five years of an unprecedented amount of money being pumped into its economy. Some experts say it could be 2017 before the Fed is in a position to raise rates.

A Good Economic Sign

Despite the stimulus slowdown being a surprise, it’s still being well received. It’s a clear sign that the Fed is confident that the economy is on a better track than it has been in half a decade. Economists say the U.S. economy is at the mid-cycle point and there’s still room to grow, but the worse is behind the world’s biggest economy. Investors were elated and sent the S&P 500 and Dow Jones soaring closing at a new record high on the date of the announcement.

The Impact On Canadian Interest Rates

The overnight lending rate in Canada has been at one per cent since September 2010. The latest decision to hold the rates in Canada came as recent at December 4th. Canada is closely watching what the U.S. does to know how our economy will react. If interest rates remain super low south of the border for the long term, Bank of Canada Governor Stephen Poloz would be in a difficult position if he raised rates and sent the dollar higher.

Put The Announcement In Perspective

The Fed is still going to buy $75-billion worth of assets each month to keep the economy chugging along. The tapering has come after 15 months of stimulus has been pumped into the economy. The U.S. already owns an excess of $4-trillion in their own. bonds.  The bond tapering is in response to housing prices being higher in the last year and the unemployment rate being at a five-year low. But these sectors are fragile and their trajectory could easily change.

It’s worth keeping an eye on how the U.S. proceeds next – any changes there will eventually impact rates for Canadian consumers and the cost of borrowing here.

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