Tapering

What Is Tapering?

Tapering is a monetary policy strategy employed by Central Banks to gradually reduce the pace of their large-scale Asset Purchases. It represents the initial phase of withdrawing from an expansionary Monetary Policy, typically following a period of Quantitative Easing (QE). During QE, a central bank buys significant amounts of government bonds and other financial assets to inject Liquidity into the financial system, aiming to stimulate Economic Growth and maintain low Interest Rates. Tapering, therefore, signals a central bank's shift towards a less accommodative stance as economic conditions improve. While the central bank's balance sheet continues to expand during tapering, it does so at a slower rate, indicating a reduction in the magnitude of monetary stimulus being provided to the economy.³⁴, ³⁵

History and Origin

The concept of tapering gained prominence following the 2008 global financial crisis. In response to the severe economic downturn, central banks, most notably the Federal Reserve in the United States, initiated unprecedented quantitative easing programs. These programs involved massive purchases of assets like Treasury Securities and Mortgage-Backed Securities to lower long-term interest rates and support the economy when short-term rates were already near zero.³², ³³

A pivotal moment in the history of tapering occurred in May 2013, an event widely known as the "taper tantrum." At this time, then-Federal Reserve Chairman Ben Bernanke hinted at the possibility of reducing the pace of bond purchases, surprising Financial Markets that had become accustomed to sustained stimulus.³⁰, ³¹ This announcement led to a sharp surge in U.S. Treasury Yields and increased volatility across global markets, particularly impacting emerging economies.²⁷, ²⁸, ²⁹ Despite the market reaction, the Fed eventually began tapering its asset purchases in January 2014, gradually reducing the monthly amount of bond buying until the program concluded in October 2014.²⁵, ²⁶ The "taper tantrum" highlighted the critical importance of clear communication and forward guidance from central banks when signaling shifts in monetary policy.²⁴

Key Takeaways

• Tapering is the gradual reduction in the pace of a central bank's asset purchases, typically following a period of quantitative easing.
• It signifies a central bank's move towards normalizing monetary policy as economic conditions improve and the need for extraordinary stimulus diminishes.
• The announcement or implementation of tapering can lead to market volatility, as seen during the "taper tantrum" of 2013.
• Tapering is distinct from quantitative tightening, as the central bank's balance sheet still expands, albeit at a slower pace, during tapering.
• The goal of tapering is to manage the transition from highly accommodative policy without destabilizing financial markets or triggering excessive Inflation.

Interpreting Tapering

Tapering serves as a crucial signal regarding the central bank's assessment of the economy's health and its future policy intentions. When a central bank announces tapering, it generally indicates that policymakers believe the economy has made sufficient progress toward their goals, such as maximum employment and price stability.²², ²³

For market participants, interpreting tapering involves understanding that while the central bank is still providing monetary accommodation, the degree of stimulus is being lessened. This often suggests that the next step in monetary policy normalization could be an increase in short-term interest rates.²⁰, ²¹ Consequently, market participants might anticipate rising bond yields and adjust their portfolio allocations accordingly. The market's reaction to tapering can reflect its perception of the central bank's communication and the overall economic outlook.

Hypothetical Example

Imagine a scenario where the economy has just emerged from a severe downturn. To support recovery, the central bank has been conducting quantitative easing, buying $100 billion of Bond Market assets each month. After several quarters, economic indicators show sustained job growth and inflation moving closer to the central bank's target.

The central bank's policymaking committee decides it's time to begin tapering. In their next announcement, they state that starting next month, they will reduce their monthly asset purchases from $100 billion to $85 billion. In subsequent months, they plan to further reduce purchases by $10 billion per month until the program reaches zero. This gradual reduction in the amount of new assets being purchased each month is the act of tapering. It communicates to markets that while the central bank remains supportive, it is slowly stepping back as the economy strengthens, paving the way for eventual policy normalization.

Practical Applications

Tapering is a key component of a central bank's toolkit for managing economic cycles and maintaining financial stability. Its practical applications primarily manifest in:

• Monetary Policy Normalization: Tapering is the first step in unwinding extraordinary stimulus measures, allowing central banks to gradually return to more conventional monetary policy tools, such as adjusting the federal funds rate.¹⁹
• Inflation Management: By reducing the inflow of new money into the financial system, tapering helps to mitigate the risk of excessive inflation that can arise from prolonged periods of high liquidity and low interest rates.¹⁸
• Market Expectations: Central banks use tapering announcements to manage market expectations about the future path of interest rates and overall economic conditions. Clear communication during tapering helps to reduce uncertainty and avoid abrupt market reactions.¹⁶, ¹⁷
• Financial Stability: Gradually withdrawing stimulus via tapering can help prevent the formation of asset bubbles and reduce the potential for instability once the economy is self-sustaining.

For instance, after the economic impact of the COVID-19 pandemic, the Federal Reserve cut short-term interest rates to zero and restarted large-scale asset purchases. As the economy rebounded in late 2021, the Fed began tapering the pace of its bond purchases, signaling a shift in its accommodative policy stance.¹⁵

Limitations and Criticisms

Despite its intended benefits, tapering is not without its limitations and criticisms. A primary concern is the potential for adverse market reactions, famously exemplified by the "taper tantrum" of 2013. This episode demonstrated that even the hint of reduced stimulus can lead to significant market volatility, including spikes in bond yields, declines in equity markets, and capital outflows from emerging economies.¹², ¹³, ¹⁴ Such reactions can tighten financial conditions prematurely, potentially hindering ongoing economic recovery.

Critics argue that central banks face a delicate balancing act during tapering: withdrawing stimulus too quickly risks stifling growth, while withdrawing too slowly could lead to overheating and unchecked inflation. The effectiveness of tapering also depends heavily on clear and consistent communication from the central bank to manage investor sentiment and avoid misinterpretations. If market participants perceive a lack of transparency or a sudden shift in policy, it can exacerbate volatility. Furthermore, some argue that quantitative easing and subsequent tapering can disproportionately benefit asset holders, potentially widening wealth inequality.¹¹

Tapering vs. Quantitative Tightening

Tapering and Quantitative Tightening (QT) are both processes that involve a central bank reducing its involvement in financial markets, but they differ significantly in their impact on the central bank's balance sheet and the broader economy.

Tapering refers specifically to the slowing down of the pace of asset purchases. During tapering, the central bank is still adding to its balance sheet, meaning its holdings of securities are still increasing, albeit at a reduced rate. It's a reduction in the flow of new money into the system.¹⁰

In contrast, quantitative tightening is the active reduction of the central bank's balance sheet. This occurs when the central bank allows maturing bonds to "roll off" (i.e., it does not reinvest the principal payments) or actively sells existing securities from its portfolio. QT directly shrinks the money supply and reduces the overall size of the central bank's assets. Essentially, tapering is the transition phase between quantitative easing and quantitative tightening.⁹

FAQs

What causes a central bank to start tapering?

A central bank typically begins tapering when it assesses that the economy has sufficiently recovered from a downturn and no longer requires the extraordinary support provided by large-scale Asset Purchases. Key indicators for this decision include progress towards goals like maximum employment and stable Inflation.⁷, ⁸

How does tapering affect interest rates?

While tapering itself is a reduction in the pace of asset purchases, it can influence market expectations, often leading to an anticipation of future increases in benchmark Interest Rates set by the central bank. This can put upward pressure on long-term Yields in the Bond Market, as investors foresee less central bank demand for bonds.⁵, ⁶

Is tapering the same as raising interest rates?

No, tapering is not the same as raising interest rates. Tapering refers to scaling back the central bank's bond-buying program. Raising interest rates, such as the federal funds rate in the U.S., is a separate Monetary Policy tool. Tapering often precedes interest rate hikes, signaling a move towards tighter monetary policy, but the two are distinct actions.³, ⁴

What is a "taper tantrum"?

A "taper tantrum" refers to a significant and often volatile market reaction to a central bank's announcement of tapering. This term originated in 2013 when the Federal Reserve's hint at reducing its bond purchases led to a sharp increase in bond yields and a sell-off in equity markets, particularly in emerging economies, due to investor fears of reduced Liquidity.¹, ²