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The Fed might taper bond buying this week. Here’s everything you need to know.

The Fed's policy committee meets Tuesday and Wednesday. (Karen Bleirer/AFP)
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The magic word on Wall Street for much of this year has been "taper." And so it is again this week, as the Federal Reserve meets to consider whether to do exactly that. Here's what you need to know.

What is the Federal Reserve?

You want this other explainer. Read it first and then get back to us.

What is tapering?

Slow down! First you have to understand the Fed's practice of buying bonds, known as quantitative easing or QE.

Okay, okay. What's QE?

The Fed normally manages the economy by either raising or lowering short-term interest rates. But it can't cut that rate below zero, where it has been for almost five years. So the Fed has tried to stimulate the economy by pumping money directly into the financial system.

It does that by buying longer-term bonds, both U.S. Treasury bonds and mortgage-backed securities issued by government sponsored companies Fannie Mae and Freddie Mac. The Fed creates money out of thin air (the electronic equivalent of printing money) and uses it to buy the bonds on the open market. Then the bonds are on the Fed's books, and the newly created money is out in the banking system.

The hope is that that extra money will find its way into other stuff. The investors who otherwise would have bought those treasury bonds and mortgage-backed securities instead have to by corporate bonds, for example, or invest it in the stock market. This has the effect of making people wealthier (because stock and bond prices are bid up) and encouraging spending and investment (because long-term interest rates are lower, for example on mortgage loans and business borrowing costs).

That's the theory, anyway. The results are more subject to dispute. The Fed's QE policies likely helped end the economic collapse in 2009, but it is less clear how much they have helped in speeding up growth in the years since then.

Currently, the Fed is buying $85 billion worth of bonds each month. The Fed's total holdings, as of Dec. 11, topped $4 trillion, compared with around $800 billion before the financial crisis.

So NOW can you explain what the taper is?

Yes! The Fed doesn't want to end the bond-buying cold turkey. It wants to slow the purchases gradually, and at a pace that can be adjusted depending on how markets and the economy react to the process. It wants to taper them off, not just end them.

The question is when to start tapering. Back in June, Chairman Ben S. Bernanke suggested the Fed would start tapering the bond buying later in 2013 and end them altogether perhaps in the summer of 2014. Markets were ready for the tapering to begin at the September Fed policy meeting, but the committee surprised markets by holding off.

The Federal Open Market Committee is meeting Tuesday and Wednesday, and it will be debating whether to begin tapering QE at the meeting. The committee will announce its decision Wednesday afternoon at 2 p.m. Eastern time, followed by a news conference by Bernanke. Markets will be holding their breath.

What's the case for tapering now?

It goes like this: QE isn't meant to go on forever, and so you need to start winding it down sometime. That sometime may as well be now.

The policy seems to be having diminishing benefits, in the sense that going from, say, $3.5 trillion to $4 trillion in assets on the Fed balance sheet didn't help markets and the economy as much as going from $2.5 trillion to $3 trillion. And it may be creating some unhappy side effects, like bubbles in emerging market bonds or for some types of corporate debt.

And the economic recovery is looking a good bit more solid than it did when the Fed met in September, averaging nearly 200,000 net new jobs a month this past fall. The unemployment rate is down to 7 percent, from 7.6 percent in June. After the confidence-rattling government shutdown in October, there is now a budget deal nearing passage that will prevent more shutdowns for the next two years and lessen the amount of drag fiscal policy is putting on the economy.

And the Fed is looking to shift its approach to stimulating the economy away from bond buying, and toward using communications about the future path of interest rates. In theory, if the central bank can successfully persuade people that it won't raise interest rates until the distant future, that should have the same impact on the economy as buying bonds, without some of the nasty side effects mentioned above.

Back in June, that subtle message wasn't getting through. Markets interpreted any wind-down of QE as also sending a message that rates will be hiked sooner. But in the months since then, dozens of Fed speeches have helped persuade markets that they really are different tools and that the end of QE doesn't mean that higher interest rates are imminent.

Against that backdrop, it's time to start the wind-down. That's what the pro-taper folks will argue at the meeting, anyway.

What are the arguments against tapering now?

Oh, sure, they will say, there have been a couple of months of decent economic data. But we've seen this show before. Every time the economy seems to be getting out of its rut, the Fed starts heading for the exits, and things get worse. We need to see a little more evidence that this faster recovery is truly entrenched before we even think about ending QE.

Second, even with growth looking a little better, inflation is still way too low -- only 1.1 percent by the Federal Reserve's preferred measure (the price index for personal consumption expenditures excluding food and energy). The Fed says it aims for 2 percent inflation; and to start winding down the money-printing operation when inflation is still too low could cost the central bank credibility. People might start to believe that the Fed isn't really serious about maintaining 2 percent inflation, making Japan-style deflation more likely.

Finally, don't be so sure that the battle to separate short-term interest rates from QE is won. Yes, there's been some clear progress on that front in the past few years, but if we seem too eager to pull away the punch bowl of bond buying, markets will inevitably assume we will do the same for low-interest-rate policies.

So is there away the people making these arguments might compromise?

There are. For example, Fed officials could agree to begin tapering bond purchases, but to start small (like reducing from $85 billion to $80 billion or $75 billion). They could announce plans to begin the tapering a month or two down the road, not immediately.

And they could consider tapering the bond buying, but complementing it with new strategies to try to bolster the credibility of their communications. For example, they could say, "Whoops, we're not going to think about raising interest rates when unemployment is 6.5 percent, as we've been saying for the past year. We'll wait until it's 6 percent." Or they could state that they have a lower bound for inflation, that they won't hike rates as long as inflation looks on track to be below, say, 1.5 percent.

In other words, if they do taper, there's a good chance it will be in conjunction with other steps to affirm the Fed's seriousness about trying to stimulate the economy.

Wait, isn't Bernanke on the way out as chairman? How does that affect things?

He is! His term is up Jan. 31, and Janet Yellen, the current vice-chair, is expected to be confirmed as early as this week to follow him. Technically that changes nothing. Bernanke is chairman until he isn't, and has to do what he thinks is best for the U.S. economy. But in practice, Yellen will likely be a more influential voice around the committee table than she would be otherwise (and she was already one of the most influential voices). It's a safe bet that whatever decision the Fed makes on Wednesday, Yellen will agree with it.

So what are they going to do?

Nobody knows for sure! It looks to be a close call. That's what will make Wednesday afternoon interesting for anybody who cares about the economy or markets. Stay tuned!