But what if those fears are unfounded? What if the taper is … tiny?
The Fed has been trying for months to separate what happens with its bond purchases, $85 billion a month, from its commitment to keeping short-term interest rates low -- but with limited success. The market expects the Fed to make a move when it's policy committee meets in September and to lean back on the pace of purchases, but there is still some hesitation within the central bank. Economic data have not pointed to any clear acceleration in growth, and inflation measures remain low. And there is fear that markets will repeat the freakout it experienced in June when the possibility of the taper was broached.
That leaves the Fed in a bind. Its leaders really do believe that what matters for the stance of monetary policy is how many assets it ends up buying, not the rate at which they are bought. Reducing the pace of purchases in September rather than December shouldn’t make a difference in a stimulus program that will likely end up tallying more than a trillion dollars. But Fed leaders have also come around to the idea that changing the pace can have broader, and potentially unwelcome, market implications. Reconciling those two positions is likely to be central to the debate within the Fed's policy committee when it meets next month.
One potential compromise would be a tiny taper. What is tiny? The Fed is currently buying $85 billion a month in Treasurys and mortgage-backed securities. Wall Street expects the central bank to cut that amount by $20 billion to $25 billion, likely starting with Treasurys. A tiny taper would be anything smaller, though a figure less than $10 billion could just look silly. In other words, in September the Fed could reduce purchases to $75 billion a month instead of the $60 billion or so Fed watchers have been expecting, and then assess the impact on the markets before deciding its next move.
A tiny taper would likely appease officials who worry that the economy is still not ready to stand on its own. But it could also satisfy those who believe the program has already gone on too long and are agitating for the Fed to get out of Dodge. Perhaps most important, it could send the signal to markets that the Fed is prepared to end (at least one phase of) the era of easy money, but that it will move carefully.
“As I see it, a decision to proceed — whether it is in September, October or December —ought to be thought of as a cautious first step,” Atlanta Fed President Dennis Lockhart said in a speech this week. And St. Louis Fed President James Bullard, who sits on the central bank's powerful policy-setting committee this year, reportedly said Thursday that he might consider a tiny taper as a potential compromise.
A tiny taper would also help push back against expectations that the reductions in bond purchases must happen at a regular and predetermined pace; in other words, the central bank officials wouldn’t feel boxed into making future moves if they did not think the data supported them.
But perhaps the most important takeaway from whatever the Fed decides next month will be that the process of crafting monetary policy is never a purely academic exercise. The path they choose will necessarily be a compromise between economic theory and financial reality, as well as the wide range of personalities who make up the committee.