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What You Need to Know about the US Federal Reserve’s Tapering

US Federal Reserve

The United States Federal Reserve has finally decided to slow its US$85 billion monthly bond-buying program, a long-anticipated and widely discussed move.

The central bank said yesterday night it will reduce monthly purchases to $75 billion in January because it’s seen enough improvement in the American economy to begin pulling stimulus. And according to the Fed’s statements, the program will likely be slowed further in coming months if the economy continues to improve.

Tapering has been a fear of markets for some time but today’s reaction was surprisingly positive for not only the American markets, but those of Asia as well. Here in Singapore, the Straits Times Index (SGX: ^STI) has also joined in the party by moving up 0.5% to 3,076 points as of 10:00am today.

What tapering really means

There are two things you should take from the Fed’s tapering decision. First, the Fed believes the American economy is improving quickly enough to slow monetary stimulus, which has helped keep long-term interest rates extremely low. The chart below shows a few of the US data points the Fed looks at when making these kinds of decisions: Unemployment rates; GDP growth; and foreclosures.

As you can see, unemployment is down, GDP growth is picking up, and foreclosures have slowed rapidly over the past three years, all great signs for America’s economic future.

The Fed needs to slow monetary aid because keeping stimulus going too long risks causing rapid inflation. In that respect, it makes sense to start slowing the program now.

The second thing investors should take away from the decision to taper is that interest rates for everything from mortgages to corporate debt will likely rise over the long term from historically low levels (though it’s certainly not a given).

As you can see below, that’s already started to happen, but tapering will slowly take a big buyer out of the market and rates will likely continue to rise long term as a result.

If rates do rise, we can’t say for sure how high or how fast it will rise either. If the American economy doesn’t have any setbacks and tapering continues in 2014 the rate rise could happen quickly, but pulling quantitative easing hasn’t led to a sharp rise in rates in the past.

This is something to keep an eye on, but definitely not something to panic over; the Fed isn’t keen on letting rates rise fast enough to kill a recovery. For the foreseeable future, any rise in interest rates will likely be slow.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. This article was written by Travis Hoium and first published on fool.com. It has been edited for fool.sg.