What Is Tapering?

A central bank’s monetary expansion policies, which are used to boost the economy, are modified via tapering. A country’s central bank may purchase asset-backed securities from its member banks as part of a quantitative easing program, infusing capital into the economy to accelerate recovery.

Once quantitative easing programs have stabilized an economy, tapering is implemented, which may include adjusting reserve requirements or the discount rate. The Federal Reserve of the United States will also keep fewer assets.

How Tapering Affects Financial Markets

Central banks often pledge to revert their stimulus measures when the economy has stabilized to boost the economy during a recession. After a recession has subsided, keeping the economy stimulated with free money may result in inflation and asset price bubbles fueled by monetary policy.

The process of either reducing or discontinuing a monetary stimulus program that has already been implemented and shown to be effective begins with tapering. Clear and honest communication with investors on the path of central bank policy and upcoming initiatives helps to reduce market uncertainty and establish expectations.

In the event of quantitative easing, the money supply and total assets held by the central bank would be decreased as the bank would declare its intention to halt asset purchases and sell off or let assets mature.

Because of “taper tantrums,” in which investors and financial markets overreact to a central bank’s decrease in stimulus, central banks may be reluctant to reverse their QE initiatives.

Monetary policymakers are incentivized to postpone their plans to unwind their balance sheets to protect their constituents’ interests in the financial sector. For instance, announcements of impending central bank tapering have historically been met with sharp increases in government bond yields and drops in equity markets.

The Federal Reserve Declining and Monetary Resources

The Federal Reserve (Fed) initiated an aggressive quantitative easing strategy in response to the COVID-19 pandemic that surfaced in March 2020. The Fed purchased assets worth over $700 billion during this period. By June 2020, it had established a QE program that involved the monthly purchase of $40 billion in mortgage-backed securities and $80 billion in Treasury securities.

The economy demonstrated notable vigor and a jump in the cost of living by the spring of 2021, when the Fed began to trim its purchases in December of the same year.

The Federal Reserve redirected its monetary policy in June 2022 in response to the growing cost inflation risk. After two years of implementing an “easy money” strategy, the Fed changed course, stopped imposing low interest rates, and made large-scale bond market interventions.

As part of its first money-tightening steps, the Fed also announced a plan to cut the approximately $9 trillion in assets it had acquired in previous years, mainly Treasury and mortgage-backed securities.

What Time Does Tapering Start?

One of the instruments the Fed uses to boost the economy is quantitative easing. Like other economic stimulus plans, QE policies are not meant to last forever. Instead, they must be progressively discontinued after attaining the targeted outcomes. A central bank’s actions can potentially send the economy into a recession if they change too quickly. Inflation may rise if a central bank keeps its economic stimulus measures the same. The phase after the stimulus, tapering, comes before rapid growth, leading to inflation.

What makes tightening different from tapering?

A central bank may implement tight or contractionary policies to restrain inflation when it is growing too rapidly, slow down economic growth, or restrict expenditure in an economy that is advancing too quickly. By altering its federal funds rate policies, also called the discount rate, the Fed may increase short-term interest rates and tighten monetary policy. Through open market operations (OMO), the Fed may also sell assets listed on the central bank’s balance sheet to the public. “Tapering” describes when monetary policy shifts from expansionary to contractionary.

Where Was the Tapering in Reaction to the Financial Crisis of 2007–2008 Evident?

Tapering occurred following the Fed’s sizable QE program, which it instituted in response to the 2007–2008 financial crisis. When former Fed Chair Ben Bernanke said in June 2013 that the Fed would cut down on the amount of assets it bought each month—as long as inflation and unemployment remained low—tapering became apparent.

By the end of 2013, the Federal Reserve Board decided that quantitative easing (QE) had served its purpose, bringing the Fed’s balance sheet up to $4.5 trillion, and tapering could begin. Smaller bond purchases would be made as part of the tapering strategy until October 2014.2.

The Final Word

Reversing a monetary stimulus program implemented and stabilizing the economy via quantitative easing measures is tapering. The Federal Reserve will decrease its asset holdings as part of tapering, which may include adjustments to the reserve requirements or the discount rate.

Conclusion 

• Tapering reverses quantitative easing measures, which central banks implement to encourage economic expansion.
• Reducing central bank assets is explicitly referred to as “tapering.”
• In reaction to tapering, financial markets may decline, dubbed a “taper tantrum.”