What Is Tapering?
Tapering modifies a central bank's monetary expansion policies initiated 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 the quantitative easing policies have stabilized an economy and may include changing the discount rate or reserve requirements. In the United States, the Federal Reserve will also reduce its asset holdings.
- Tapering is the reversal of quantitative easing policies, implemented by a central bank and intended to stimulate economic growth.
- Tapering refers specifically to the reduction of central bank assets.
- Financial markets may experience a downturn in response to tapering, known as a "taper tantrum."
Click Play to Learn All About Tapering
How Tapering Affects Financial Markets
When central banks pursue an expansionary policy to stimulate an economy in a 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 monetary policy-driven asset price bubbles.
Tapering is the first step in the process of either winding down or withdrawing from a monetary stimulus program that has already been executed and deemed successful. Communicating openly with investors regarding the direction of central bank policy and future activities helps to set market expectations and reduce market uncertainty.
In the case of quantitative easing, the central bank would announce its plans to slow asset purchases and either sell off or allow assets to mature, thus reducing the amount of total central bank assets and the money supply.
Central banks can hesitate to pull back on their QE policies due to "taper tantrums," where investors and financial markets overreact to a reduction in stimulus from the central bank.
For example, announcements of impending central bank tapering have typically been met with sharp rises in government bond yields and drops in equity markets, creating an incentive for monetary policymakers to delay plans to unwind their balance sheets to avoid harming the interests of their constituents in the financial sector.
Federal Reserve Tapering and Financial Assets
As the COVID-19 pandemic emerged in March 2020, the Fed implemented an aggressive quantitative easing strategy, injecting more than $700 billion in asset purchases, and by June 2020 established a QE program to purchase $80 billion in Treasury securities and $40 billion in mortgage-backed securities per month.
The Fed started tapering its purchases in December 2021 and by the spring of 2021, the economy showed significant strength and a cost-of-living surge.
In June 2022, the Federal Reserve changed its monetary policy direction to manage the threat of rising costs. The Fed revised its position after two years of an “easy money” policy, ending its policy of low-interest rates and significant intervention in the bond market.
The Fed also put in place a plan to reduce its balance sheet of nearly $9 trillion in asset holdings it accumulated in recent years, mostly Treasury and mortgage-backed securities the beginning of the Fed’s money-tightening measures.
When Does Tapering Begin?
The Fed implements quantitative easing as one of its tools to stimulate the economy. Like all economic stimulus programs, QE policies are not intended to be permanent and after the desired results of an economic stimulus program have been achieved, those policies must be gradually rescinded. If a central bank changes its operations too fast, it can push the economy into a recession. If a central bank never eases its economic stimulus policies, there may be an increase in inflation. Tapering is the period where the stimulus has worked and before an accelerated expansion toward inflation.
What Is the Difference Between Tapering and Tightening?
Tight, or contractionary policy is a course of action by a central bank to slow down economic growth, constrict spending in an economy that is seen to be accelerating too quickly, or curb inflation when it is rising too fast. The Fed tightens monetary policy by raising short-term interest rates through policy changes to the discount rate, also known as the federal funds rate. The Fed may also sell assets on the central bank's balance sheet to the market through open market operations (OMO). Tapering refers to the period of reversal between expansionary policy and contractionary monetary policy.
Where Was Tapering Evident in Response to the 2007-2008 Financial Crisis?
Tapering by the Fed followed the massive QE program implemented in reaction to the 2007-08 financial crisis. Tapering was evident in June 2013 when the former Chair of the Fed, Ben Bernanke, announced that the Fed would reduce the number of assets purchased every month as long as economic conditions, such as inflation and unemployment, were favorable.
As 2013 drew to a close, the Federal Reserve Board concluded that QE, which had increased the Fed's balance sheet to $4.5 trillion, had achieved its intended goal, and it was time for tapering to commence. The process of tapering would involve making smaller bond purchases through October 2014.
The Bottom Line
Tapering is withdrawing from a monetary stimulus program that has been executed and quantitative easing policies have stabilized the economy. Tapering may include changing the discount rate or reserve requirements and the Federal Reserve will also reduce its asset holdings.