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The Federal Reserve Changes Strategy As The Economy Begins To Recover

SUSAN DAVIS, HOST:

The Federal Reserve is preparing to do something tricky. When markets tanked at the beginning of the pandemic, the Fed went all in. The central bank has bought more than a trillion dollars' worth of bonds and securities. Now the economy's recovering. Markets are setting records. And the Fed needs to put an end to those purchases without tanking the markets. Fed Chair Jerome Powell could share details on how the bank plans to do that in a highly anticipated speech this week. But here to explain now is NPR's David Gura. Hey, David.

DAVID GURA, BYLINE: Hey, Sue.

DAVIS: So let's start with the buying spree that the Fed's been on. What are the economics behind it?

GURA: Let's go back to March of 2020. Everything is shutting down. Investors are panicking. And the Fed Reserve, which hasn't forgotten what happened during the last financial crisis, says, essentially, we've got to do something big. And in that moment, the Fed wants to stabilize things. It wants to project confidence in U.S. markets. It also wants to keep the economy moving - to keep people buying things and borrowing money. And for that, it wants to keep interest rates low. So the Fed Reserve starts buying tens of billions of dollars of bonds and mortgage debt month after month after month. Keep in mind the bond markets determine all kinds of rates you and I pay, from mortgages to car loans. So the Fed has been effectively flooding the economy with cheap credit. Here we are about a year and a half later, and there's this sense this bond-buying program may have outlived its usefulness. The economy is recovering. Jobs picture is improving. And Sue, as you said, the stock market is at record levels.

DAVIS: So how hard is it to take that tool and then put it away?

GURA: That's not easy. And this is going to be a delicate dance. We do know the Fed Reserve is not going to stop buying these bonds cold turkey because that would shock the market. Investor Mohamed El-Erian is the chief economic adviser at Allianz.

MOHAMED EL-ERIAN: What the Fed worries about is that the minute it starts taking away the liquidity, markets will become not just volatile but dysfunctional.

GURA: So what the Fed is going to do is it's going to start buying fewer assets every month. It's going to taper its purchases. And that's a term you're going to hear a lot. The thinking is a taper will give the market time to adjust. So we know what's going to happen, but we still don't know when it's going to happen and how. And we may get some answers in a few days when Jerome Powell speaks at this big economic symposium - usually held in Jackson Hole, Wyo., - but this year it's going to be online. And if Powell doesn't share details then, it's likely he will at the next Fed meeting in September.

DAVIS: This idea of tapering - that makes sense. But what makes this so tricky? What are the risks if they get it wrong?

GURA: The biggest risk is the Fed does this too early and puts away a tool it still needs. What if there's a big resurgence of COVID-19, or the delta variant does real damage to the economic recovery? Economists and investors have not forgotten the way this unfolded last time. After the financial crisis, the Fed was starting to make plans for how it would taper purchases it was making then when Ben Bernanke hinted at what he was thinking during an appearance on Capitol Hill. Wall Street wasn't prepared for that. There was a big sell off, and the market had what came to be called the taper tantrum.

DAVIS: (Laughter) What did the Fed learn from that taper tantrum in 2013?

GURA: A couple of things, I think. First of all, that clear communication is key. Powell was on the Fed board during the taper tantrum, so he's been really careful about what he says. The other lesson is commitment. Mohamed El-Erian says the Fed buying all these assets is like a parent giving candy to his kid. After a while, dad has to take it away.

EL-ERIAN: Yes, there may be some issues in the beginning. There may be a tantrum. But the response to that is not to continue feeding your kid candy all the time. The response to that is to do the right thing and manage through the tantrum.

GURA: So he's saying the Fed needs to be resolute, and it needs to recognize that if you keep using the tool after it's no longer effective, we risk doing real damage to the economy.

DAVIS: That's NPR's David Gura. David, thanks.

GURA: Thank you. Transcript provided by NPR, Copyright NPR.