The Federal Reserve promised it would move slowly in winding down its $1 trillion stimulus program. The jittery past few days in the markets are demonstrating why that might have been a good idea.
Central bank officials weren’t sure how investors would react when it announced last month that it would begin scaling back its support for the U.S. economy. And who can blame them? Markets initially seemed to cheer the decision as a vote of confidence in the American economy, rallying to record highs after the announcement. Now, sentiment seems to have reversed, with fears of the Fed taper helping to drive the global sell-off in stocks, bonds and currencies over the past few days -- the most significant declines in five years.
This type of bipolar reaction to the Fed’s movements is exactly why central bank officials opted to go easy in the first place. The initial $10 billion reduction in stimulus announced in December was about half of what many analysts were predicting just a few months earlier. Officials were particularly concerned about the impact on developing countries, which had been flooded with capital as investors hunted for returns while the Fed held down interest rates in the U.S. An abrupt reversal of that flow of investment could destabilize emerging market economies.
Although Fed officials have argued that the central bank's primarily responsibility is to support sustainable growth in America, they are also keenly aware that their actions are under unique scrutiny -- and that anxiety overseas can quickly infect the U.S. The global selloff ended on Friday with the Standard & Poor’s 500-stock index down nearly 2 percent, the biggest loss so far this year. On Monday, stocks took another dive, with the S&P 500 dropping about a half percentage point, again on emerging market concerns.
The worldwide rout is unlikely to deter the Fed from continuing to reduce the amount of money it is pumping into the U.S. economy by $10 billion to $65 billion a month as officials convene in Washington Tuesday and Wednesday. The central bank wants to move deliberately, minutes of its last meeting show, out of “concern about the potential for an unintended tightening of financial conditions." That covers both the United States and the rest of the world.
The Fed has already indicated that future reductions would occur in similarly measured steps at each upcoming meeting, assuming the U.S. economy continues to improve as planned. The meeting will also be the last for chairman Ben S. Bernanke before he steps down at the end of the week, providing yet another reason not to veer off course.
The challenge the Fed faces now is convincing investors that they should take comfort in the fact that the central bank is keeping its promise.