Fed Begins Tapering and the Dollar Reacts

The Fed has announced that it will begin slowing its monthly bond purchases. How does tapering affect the dollar?

The reduction in bond purchases will begin later this month, the Federal Open Market Committee said after its monetary policy meeting yesterday.

The process will consist of $15 billion in reductions each month. These will be divided into $10 billion in Treasuries and $5 billion in mortgage-backed securities.

Markets were expecting this change in U.S. monetary policy, and it did not come abruptly, as the amounts agreed upon for the reduction are not that high.

Global markets showed a positive reaction to the result of the  Federal Reserve (Fed) meeting.

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Proof of this was reflected in the fact that Wall Street closed with rises of more than 1% in all its indexes. This correlates with what happened in most European and emerging stock markets, which received the news of the start of tapering with moderate gains.

How Does Tapering Work?

Central bank officials indicated Wednesday that they are ready to begin "tapering," which is the process of slowly withdrawing the monetary stimulus they have provided during the pandemic.

For most of the past year and a half, the Fed has been buying at least $120 billion in bonds each month, providing unprecedented support to financial markets and the economy that it will now begin to reverse.

The bond purchases have added more than $4 trillion to the Fed's balance sheet, which now stands at $8.5 trillion, about $7 trillion of which are assets purchased through the Fed's quantitative easing programs, according to central bank data.

The purchases have helped keep interest rates low, have provided support for markets that have performed poorly since the start of the pandemic crisis, and have coincided with a powerful stock market rally, CNBC said in a report.

What Did the Federal Reserve Say in Its Statement?

  • The Fed said with progress on vaccinations and strong policy support, indicators of economic activity and employment have continued to strengthen.
  • The sectors most adversely affected by the pandemic have improved in recent months, but the summer's rise in COVID-19 cases has slowed their recovery.
  • Inflation is elevated, largely reflecting factors that are expected to be transitory. Supply and demand imbalances related to the pandemic and the reopening of the economy have contributed to sizable price increases in some sectors.
  • Overall financial conditions remain accommodative, in part reflecting policy measures to support the economy and the flow of credit to U.S. households and businesses.
  • The path of the economy continues to depend on the course of the virus. Progress on vaccinations and an easing of supply constraints are expected to support continued gains in economic activity and employment as well as a reduction in inflation. Risks to the economic outlook remain.
  • The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent.

Tapering Is a Fact

Beginning this month, the Committee will increase its holdings of Treasury securities by at least $70 billion per month and agency mortgage-backed securities by at least $35 billion per month.

Beginning in December, the Committee will increase its holdings of Treasury securities by at least $60 billion per month and agency mortgage-backed securities by at least $30 billion per month.

The Committee believes that each month is likely to slow the pace of net purchases of similar assets, but is prepared to adjust the pace of purchases if changes in the economic outlook warrant it.

The Fed's continued purchases and holdings of securities will continue to promote smooth market operations and accommodative financial conditions by supporting the flow of credit to households and businesses.

Fed Chairman, Jerome Powell said he expects inflation to keep rising as supply issues continue and then start to pull back around the middle of 2022.

How Does Tapering Affect the Dollar?

We cannot forget that one of the assets most sensitive to the evolution of US bonds is the bonds of emerging countries.

Rising interest rates in the US reduce the attractiveness of investing in other currencies, putting pressure on exchange rates and bond prices in emerging markets.

The Fed's announcement is in line with what the market anticipated. This reflects that investors do not see a Fed overly concerned about inflation.

Moreover, investors do not see a Fed that is about to pull the trigger to raise interest rates, and they are celebrating by buying risky assets. However, the rate of the reduction clears the way for a possible interest rate hike in the second half of 2022.

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