For those of you who do not live and breathe monetary policy, events this week might have been a bit difficult to parse. Why did markets (seem to) respond to the announcement that Larry Summers would not seek the Fed chairmanship? The Fed did “nothing” on Wednesday, yet stock and bond markets rallied. There was some reference to “tapering,,” but what is that and why would it matter that the Fed did nothing about it?
All good questions! On Sunday afternoon, Lawrence Summers announced that he would not seek the Fed chairmanship, for reasons we don’t need to get into. When markets opened on Monday morning, stock prices rose and long-term bond yields (interest rates) fell. How come? Mr. Summers was viewed as (a) the front-runner among possible successors to Chairman Bernanke, and (b) less supportive of the view that Fed actions to lower long-term interest rates (“quantitative easing,” more on that below), were effective in stimulating the economy. Because there was a chance he would become chairman, and perhaps pull back on the Fed’s stimulus sooner than other candidates, markets saw his withdrawal as lowering the chances that the Fed would tighten monetary policy. So they liked that, and rallied–lower interest rates, higher stock prices.
So what’s quantitative easing (QE)? That’s when the Fed buys a bunch (trillions of $, actually) of Treasury bills and bonds and mortgages. When the Fed buys these assets, they are removed from the private markets onto the Fed’s balance sheet. Because the private markets still would like to have such assets themselves, and they are now in shorter supply, they bid up their prices, which lowers their yields (interest rates). And that’s what the Fed wants–to lower the interest rates in private markets on things like mortgages and auto loans and business loans. So by buying up these assets, they push those interest rates down, other things being equal. Of course, other things are not always equal, but that’s a story for another post.
What happened on Wednesday? Well, that’s a bit more complicated. The Fed has been buying about $85 billion of Treasuries and mortgages per month, which adds up over time–to a grand total that will probably exceed $1 trillion. The more they buy in total, the lower interest rates will go, according to the logic above. If they slow the monthly pace of purchases (or “taper”)–to, say, $75 billion a month–that could mean that the total purchased would be less, which would imply less downward pressure on interest rates. Of course, traders who buy and sell such securities would be very interested to know the Fed’s plans to buy more or less of them, as this would affect their prices and thus the traders’ profits.
Late in the spring, and over the summer, a combination of Fed statements and market speculation led many to believe that the Fed was going to reduce the pace of purchases at its September meeting. To be clear, there was never any explicit promise of this, but that’s the way the market betting was going. To the surprise of many, the Fed announced on Wednesday afternoon that it would continue purchasing securities at the pace of $85 billion a month–no tapering! That implied we would buy more securities in total, keeping interest rates somewhat lower (other things equal). And so the markets took that news on board, bidding up the prices of stocks and bidding down the yields on Treasuries and mortgages.
So that’s what happened. What do we learn from this? The communication about the Fed’s plans to purchase securities, for how long and at what monthly rate, is very important to markets and to the economy. It’s also pretty complicated to get just right. IMHO, we still have some more to learn about how best to do this.