The Federal Reserve has a gargantuan task ahead of itself, but investors are hoping it will be orderly and calm. In just a few weeks, the central bank will begin to gradually unwind the massive stimulus efforts it enacted in the wake of the Great Recession.
The decision, which was announced Wednesday, came with little fanfare after central bank officials had alluded to a potential wind-down for months. Nevertheless, the announcement was momentous. Just as the Fed’s crisis-era stimulus efforts were unprecedented in size, so too is an unwind of this magnitude.
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What does it mean for your wallet? There are many unknowns, but economists say Main Street has little to worry about. If all goes well, the impact on your savings account, mortgage and 401(k) balance should be so gradual you’ll hardly even notice it at first. In a press conference on Wednesday, Fed Chair Janet Yellen described the runoff process as “gradual” and “predictable.”
Andrew Hunter, U.S. economist for Capital Economics, called it a “historic moment” but added: “In truth, however, the move has been so well telegraphed and, at just $10 billion per month initially, the pace of run-down will be so gradual that it is unlikely to have a major impact on the economy or financial markets.”
In other words, “the Federal Reserve’s goal is to make this a boring process,” says Beata Caranci, chief economist for TD Bank.
Remind me again…what is the Fed doing? Put simply, the Federal Reserve is slowly starting to undo a policy known as quantitative easing, also referred to as QE in Wall Street circles. But what is quantitative easing?
After the financial crisis, the Fed tried to reinvigorate the U.S. economy by cutting its key interest rate to near zero. The hope was that low interest rates would stimulate the economy by making it more attractive for businesses to take out loans and homebuyers to take out mortgages.
But in the depths of the recession in 2008, the Fed found its near-zero interest rates still didn’t provide enough oomph to the economy, so the central bank launched a controversial and unprecendented policy, buying trillions of dollars in U.S. Treasury bonds and mortgage-backed securites. That bond-buying spree (known as quantitative easing) put further downward pressure on interest rates, making everything from mortgages to business loans even cheaper for borrowers.
Over time, the Fed quintupled its bond holdings from $900 billion in 2007 to about $4.5 trillion. Critics warned that the bond purchases could collapse the bond market or lead to runaway inflation, but so far, neither of those dire predictions has materialized.
Quantitative easing ended in 2014, and since then, the Fed has kept its balance sheet steady. When the bonds mature, the Fed rolls them over by reinvesting the principal payments into new bonds. Starting in October, however, the Fed will gradually reduce those reinvestments. Over time, as the Fed rolls over fewer bonds, its balance sheet should gradually shrink.
What does this mean for my savings or debt? Federal Reserve economists estimate that quantitative easing lowered the yield on the 10-year Treasury note by one percentage point. This matters because the 10-year Treasury is considered a benchmark in the U.S. economy, influencing other interest rates on corporate bonds, mortgages and business loans.
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Just as quantitative easing helped to lower interest rates for borrowers, the unwinding of the policy should gradually lead to higher interest rates on everything from your savings account to 30-year mortgages and auto loans. “The Fed bought bonds to drive interest rates down, and very slowly over time, as they reduce their holding of bonds, that will mean long-term interest rates will move higher,” says Julia Coronado, economist and founder of MacroPolicy Perspectives. “They’re trying very hard to make this as gradual and orderly and predictable a process as possible.”
As a result, consumers and business owners should be prepared for loans to become more expensive. This is not necessarily a bad thing, though. The economy is on stronger footing, unemployment is low and the stock market is at record highs. It’s only natural that interest rates should rise, Caranci says.
Plus, the Fed’s runoff coincides with gradual rate hikes. The Fed raised its key interest rate twice this year, and market participants generally expect another rate hike in December. “Yields need to rise. Period. People should be expecting higher interest rates as we go into next year,” Caranci says.
That said, the effect should be gradual. Federal Reserve economists predict that six years from now — in 2023 — the balance sheet will still not be fully unwound, and the central bank’s crisis-era bond purchases will still be holding the 10-year Treasury yield about 0.24 percentage point lower from where it would be otherwise.
What will happen to the stock market? Stocks are near record highs, and years of Fed stimulus certainly played a partial role in fueling those gains. As bond rates fell, investors searched for higher yields, and some turned to equities instead.
But now that the Fed is unwinding its stimulus, that doesn’t necessarily mean stocks will retreat from their record highs.
The Fed clearly choreographed the unwinding of its balance sheet ahead of time, and because investors weren’t surprised by the decision, it’s unlikely there will be a sudden market shock, Caranci says.
Plus, now that the economy is in a much stronger place than it was during the financial crisis, the stock market may be less sensitive to changes in monetary policy. “The stock market tends to be driven by a lot of things, but in general, the stock market likes it when interest rates are low. Higher interest rates might take some steam out of the market,” Coronado says. “But if the Fed is reducing its balance sheet because the economy is doing very well, then the market should be OK. The state of the stock market lies in the economic forces.”
At a press conference, a reporter specifically asked Yellen if she was worried about stocks at record highs. Her response? “It’s not easy to get a clear read on the implications of asset prices for the overall outlook.”
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What should I do now? Economists generally expect the Fed will raise its key interest rate again in December. Ahead of that announcement, Greg McBride, chief financial analyst for Bankrate.com, recommends borrowers pay down debt. “Use the reprieve from rising interest rates to pay down costly credit card debt and reduce the balance on your home equity line,” he says. “The next Fed hike — whether December or sometime in 2018 — will push your rates even higher.”
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How the Fed’s Great Unwind Affects Your Wallet originally appeared on usnews.com
