Fed's 'tapering' likely to usher in higher rates

6:34 PM, Aug. 15, 2013  |  Comments
  • Filed Under

Get ready to pay higher interest rates for that new car loan or 30-year mortgage.

That will be the result when the Federal Reserve Bank finally begins to taper its bond buying activity, also known as quantitative easing.

Some economists expect tapering to begin as early as September.

But what is "tapering?" The word is getting thrown around a lot in the media, so to explain, let's start with the mission of the Federal Reserve Bank.

The Fed's mandate comes from Congress

Congress has tasked the Fed with a joint mandate: pursue policies that will result in full employment and stable prices.

The main tool that the Fed uses to influence the economy is controlling the level of short-term interest rates.

Unfortunately, the Fed used up this tool almost five years ago when it dropped the Federal Funds rate (the interest rate that banks use to loan to one another) to the 0 percent to 0.25 percent range in December 2008.

The theory behind lowering interest rates is that it should make it cheaper for consumers and businesses to borrow money, resulting in faster economic growth. Though this was intended to be a short-term emergency measure, it is still in place.

There are differing opinions on how well this zero percent interest rate policy worked. One negative result was the fact that interest on savings accounts, money market funds and certificates of deposit dried up for savers, many of whom are retirees.

This lack of earnings continues to act as a depressant on the economy as much of this interest on savings is normally spent.

The theory behind quantitative easing

To explain the next step, quantitative easing, we need to re-visit a basic economic principal.

When there is more demand for a product, the seller can ask a higher price for it (in the case of bonds, interest rates will fall as prices rise.)

With QE, the Fed injects money into the banks by buying their U.S. Treasury and mortgage-backed bonds.

The Fed is currently buying $85 billion of these securities from the banks every month. This creates an artificial "demand" for these bonds, thereby pushing up the price and keeping the interest rates lower than they would be otherwise.

The Fed is also hoping that this additional liquidity will result in more lending activity by the banks, though the jury is still out.

Stock markets in particular have reacted very favorably to the Fed's actions for much of the last five years. However, remember that these moves were designed as short-term, emergency measures by the Fed and will have to be ended eventually as the economy improves. If not, hyperinflation would be the likely result.

What to expect when the tapering begins

This gets us to the term "taper."

This refers to a slowing of the current $85 billion per month of Fed bond purchases.

When tapering starts, the bond market will have less artificial "demand" so bond prices should begin falling causing interest rates to rise.

As interest rates begin to rise, the better return from bonds will draw some money from investors who would otherwise be buying stocks.

Corporations and consumers will have to pay more to borrow.

This all may sound like bad news for the stock side of your 401(k), but it's important to keep in mind that the only reason for the Fed to begin tapering is because it believes the economy is improving.

And an improving economy should prove favorable for stock investors.

So if you're waiting for lower rates to refinance or buy a house, you may be waiting for a very long time.

Sure, rates may drop another 0.25 or even 0.5 percentage point, but from a historical perspective, rates are still extremely low.

Trying to pick the exact bottom in rates is a losing game, just like trying to pick a number on the roulette wheel.

If the rate difference of 0.25 percentage point means you will struggle with the payments, you probably can't afford the house to begin with.

Additionally, if you want to refinance, do it very soon.

If you want to buy a house and you can afford it, find one you like and make the move.

It's only a question of "when," not "if," the Fed will begin to taper. We're currently in uncharted territory when it comes to the Fed's influence on the economy and the markets.

So the best way to approach this brave new world is by wearing blinders: Try to ignore most of the noise surrounding tapering and don't try to time your investment moves based on the Fed's actions. It's critical you focus on the longer-term, multi-year outlook, which should be coupled with your financial plan. ■

Nathan Bachrach and Ed Finke

Simply Money

Buy & Sell



  1. Mobile Site
  2. Mobile App
  3. Reds Baseball App
  4. Bengals Football App
  5. Things to Do App

Real Deals
