What is Tapering?
Tapering modifies a central bank’s monetary expansion policies that were initially implemented to stimulate an economy. During a program of quantitative easing, a nation’s central bank may buy asset-backed securities from its member banks, injecting money into the economy to boost recovery.
Tapering is initiated after quantitative easing policies have stabilized the economy and can include changing the discount rate or reserve requirements. In the United States, the Federal Reserve will also reduce its asset holdings.
Key Takeaways
- Tapering is the reversal of quantitative easing policies, aimed at stimulating economic growth.
- It involves the reduction of central bank assets.
- Financial markets may experience downturns in response to tapering, commonly referred to as a “taper tantrum.”
How Tapering Affects Financial Markets
When central banks pursue expansionary policies to stimulate an economy in recession, they promise to reverse their stimulatory policies once the economy has recovered. Continuing to stimulate an economy with easy money once a recession has eased can lead to inflation and asset price bubbles.
Tapering is the first step in the process of pulling back from a monetary stimulus program that has succeeded. Open communication with investors about the direction of central bank policy and future activities helps mitigate market uncertainties.
In quantitative easing, the central bank announces its plans to slow down asset purchases and either sell off or allow assets to mature, reducing the total central bank assets and money supply. Central banks can hesitate to retract QE policies due to “taper tantrums,” where financial markets overreact to reduced stimulus.
For instance, announcements of impending tapering typically result in sharp rises in government bond yields and drops in equity markets, creating a dilemma for monetary policymakers who wish to avoid quick unwinding of their balance sheets.
Federal Reserve Tapering and Financial Assets
During the COVID-19 pandemic in March 2020, the Fed activated aggressive quantitative easing, injecting more than $700 billion in asset purchases. By June 2020, it established a program to purchase $80 billion in Treasury securities and $40 billion in mortgage-backed securities monthly.
The Fed initiated tapering in December 2021, and by spring 2021, the economy showed considerable strength and rising costs of living. In June 2022, to manage inflation threats, the Fed reversed its stance, ending the low-interest rate policy and significant bond market intervention and set out to reduce its balance sheet of nearly $9 trillion.
When Does Tapering Begin?
Quantitative easing is a tool for economic stimulus, implemented until desired economic outcomes are achieved. Post-stimulation, policies must be slowly rescinded—if done too quickly, it could lead to a recession; if delayed, rising inflation could ensue. Tapering occurs when stimulus impacts are realized but before significant inflationary expansion begins.
What Is the Difference Between Tapering and Tightening?
Tightening, or contractionary policy, aims to slow economic growth, reduce spending momentum, or curb swiftly rising inflation. The Fed tightens monetary policy by increasing short-term interest rates, also known as the federal funds rate, and through the sale of assets from its balance sheet. Tapering refers to the period of gradual policy reversal between expansionary and contractionary phases.
Where Was Tapering Evident in Response to the 2007-2008 Financial Crisis?
The Fed’s tapering followed the extensive QE program in reaction to the 2007-08 financial crisis. In June 2013, then-Chair Ben Bernanke announced a reduction in asset purchases contingent on favorable economic conditions such as inflation and unemployment. By the end of 2013, as QE’s impact reached its peak, tapering commenced with incremental reductions in bond purchases through October 2014.
The Bottom Line
Tapering involves withdrawing from monetary stimulus programs. It includes adjusting the discount rate or reserve requirements, and reducing the Federal Reserve’s asset holdings after quantitative easing policies stabilize the economy.
Related Terms: quantitative easing, monetary policy, financial markets, inflation.
References
- U.S. Bank. “Federal Reserve Concludes Tapering as It Recalibrates Monetary Policy to Fight Inflation”.
- Federal Reserve System. “Transcript of Chairman Bernanke’s Press Conference”, Page 5.
