What Is Tapering?
Tapering refers to policies that modify traditional central bank activities. Tapering efforts are primarily aimed at interest rates and at controlling investor perceptions of the future direction of interest rates. Tapering efforts may include changing the discount rate or reserve requirements.
Tapering may also involve the slowing of asset purchases, which, theoretically, leads to the reversal of quantitative easing (QE) policies implemented by a central bank. Tapering is instituted after QE policies have accomplished the desired effect of stimulating and stabilizing the economy.
Tapering can only be instituted after some kind of economic stimulus program has already been operated.
- Tapering is the theoretical reversal of quantitative easing (QE) policies, which are implemented by a central bank and intended to stimulate economic growth.
- Tapering refers specifically to the initial reduction in the purchasing of and accumulation of central bank assets.
- As a result of their dependence on sustained monetary stimulus under QE, the financial markets may experience a downturn in response to tapering; this is known as a "taper tantrum."
- Taper tantrums may lead central banks to promptly re-accelerate asset purchases (and essentially reverse the process of tapering).
- Central banks, for the most part, have not been able to sustainably unwind their expanded balance sheets.
Tapering is the reduction of the rate at which a central bank accumulates new assets on its balance sheet under a policy of QE. Tapering is the first step in the process of either winding down—or completely withdrawing from—a monetary stimulus program that has already been executed.
When central banks pursue an expansionary policy to stimulate an economy in a recession, they often explicitly promise to reverse their stimulatory policies once the economy has recovered. This is because continuing to stimulate an economy with easy money once the recession is over can lead to out-of-control inflation, monetary policy-driven asset price bubbles, and an overheated economy.
How Do Central Banks Execute Tapering?
Communicating openly with investors regarding the direction of central bank policy and future activities helps to set market expectations and reduce market uncertainty. This is why central banks typically employ a gradual taper, rather than abruptly halting expansionary monetary policies.
Central banks help alleviate any market uncertainty by outlining their approach to tapering and by outlining the specific conditions under which tapering will either continue or discontinue. In this regard, any foreseen reductions in QE policies are communicated about in advance, allowing the market to begin making adjustments prior to the activity actually taking place.
In the case of QE, the central bank would announce its plans to slow asset purchases and either sell off or allow assets to mature. This is intended to reduce the amount of total central bank assets and, in turn, the money supply.
History Reveals Tapering Is a Theoretical Activity
At various points in time, the U.S. Federal Reserve (the Fed)—and other central banks that have engaged in QE in recent decades—have announced intentions to eventually taper and reverse QE. However, central banks have thus far proven unable or unwilling to engage in sustained tapering, much less a complete reversal, of their QE policies.
The U.S. Fed, Bank of England, European Central Bank, Bank of Switzerland, and Bank of Japan have all proposed or attempted to taper or unwind their QE policies, only to subsequently renew and accelerate asset purchases and continue expanding their balance sheets.
Sweden's Central Bank, the Sveriges Riksbank, made the most successful move so far toward reducing its balance sheet from 2010 to 2011, but has steadily expanded its balance sheet since then to nearly double its previous peak. As a result, the theoretical idea of central banks tapering or unwinding QE remains a largely empty promise rather than a real possibility.
One explanation for why central banks are reluctant to pull back on their QE policies is the recurrence of so-called "taper tantrums." Investors (and the financial markets as a whole) can react in extreme ways to the possibility that stimulus from the central bank might slow.
For example, announcements of impending central bank tapering have typically been met with sharp rises in government bond yields and drops in equity markets. This creates a powerful incentive to monetary policymakers to either delay or reverse plans to unwind their balance sheets because they want to avoid harming the interests of their constituents in the financial sector.
Example of Tapering
In the U.S., the Fed's QE programs have involved the purchasing of assets, including mortgage-backed securities (MBS) and other assets with long-term maturities, to help bring down interest rates. These purchases reduce the available supply of bonds on the open market, resulting in higher prices and lower yields (i.e., long-term interest rates).
Lower yields lower the cost of borrowing. Theoretically, a lower cost of borrowing should make it easier for businesses to finance new projects, which also raises employment. And an increase in employment levels should lead to an increase in overall consumption and economic growth.
Essentially, QE is one monetary policy tool that the Fed can use to stimulate the economy. When QE is undertaken, the Fed promises these policies will be rescinded gradually, or tapered, once the objective of these policies has been met.
Federal Reserve QE Program After the 2007–2008 Financial Crisis
A recent example of attempted tapering by the Fed followed the massive QE program implemented in reaction to the 2007-08 financial crisis. Tapering came to the fore 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. In this case, tapering referred to the reduction, not the elimination, of Fed asset purchases.
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 Federal Reserve's Tapering Plan
At the beginning of 2014, the Fed announced its intention to reduce its monthly purchases from $75 billion to $65 billion. Tapering would start at $6 billion a month for Treasury securities and $4 billion for MBS. The process would be capped at $30 billion for Treasury securities and $20 billion for MBS; once these levels were reached, additional payments would be reinvested.
At this pace, the Fed's balance sheet was expected to fall below $3 trillion by 2020. Instead, facing a stiff and immediate market taper tantrum, the Fed maintained its balance sheet at around $4.5 trillion through early 2018. At this point, it began a very gradual reduction in its assets.
By mid-2019, market reaction to the mild pullback in QE had resulted in an inverted yield curve and increasing indications of an impending recession. Once again, the Fed began accelerating its QE policies (by increasing its bond purchases), with assets exceeding $4 trillion in December 2019 and exploding over $7 trillion in early 2020, as fears of the coronavirus gripped the Fed.
In the aftermath of the COVID-19 pandemic, the Fed implemented many expansionary policy measures to guide the recovery of the economy. At the end of May 2021, after meeting notes were released from a central bank policy meeting in April, speculation began among investors that the Fed might begin tapering off bond purchases. According to the meeting notes, "a number of participants suggested that if the economy continued to make rapid progress toward the Committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases.”
What Is the Origin of Tapering?
Tapering can only occur after some kind of economic stimulus policies have already been put in place. A recent example of this kind of economic stimulus was the quantitative easing (QE) program implemented by the U.S. Fed in response to the financial crisis of 2007-08.
This QE program was intended to broaden the Fed's balance sheet by purchasing long-maturity bonds and other assets. The Fed's purchases drove down the supply available, which led to higher prices and lower yields (long-term interest rates).
Lower yields, in turn, lower the cost of borrowing. This was intended to make it easier for companies to fund new projects that generate new jobs. And theoretically, an increase in employment would lead to higher demand and economic growth.
After the financial crisis, the Fed used QE as one of its tools to stimulate the economy. Like all economic stimulus programs, QE policies are not intended to be permanent. Eventually, after the desired results of an economic stimulus program have been achieved, those policies must be gradually rescinded.
This is where the concept of tapering originates; 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, an undesirable effect could be an unwanted increase in inflation.
How Does Tapering Affect the Stock Market?
The QE policies implemented in the aftermath of the financial crisis of 2007-08 had a favorable impact on the prices of stocks and bonds in the U.S. financial markets. As a result, investors were concerned about the impact of a potential reduction—or tapering off—of these favorable policies.
Since tapering is a theoretical possibility—it has never actually been successfully carried out by central banks that instituted an economic stimulus driven by QE—it is hard to say exactly what impact tapering would have on the stock market. However, in the past, it was widely believed that once the Fed began the slow reversal of its economic stimulus, the stock market would react negatively.
What Is the Difference Between Tapering and Tightening?
In the context of monetary policy, tight, or contractionary, policy is a course of action undertaken by a central bank—such as the Fed in the U.S.—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).
Tightening monetary policy is the opposite of expansionary monetary policy. Expansionary, or loose, policy seeks to stimulate an economy by boosting demand through monetary and fiscal stimulus. QE is a tool of expansionary monetary policy.
So, tapering refers to a reversal of one aspect of a loose monetary policy—QE—while tightening refers to the implementation of tight monetary policy. The tapering off of asset purchases by the Fed can occur at the same time as a program of expansionary monetary policy. Even though both tapering and tightening are intended to have similar effects on market interest rates, they do not always happen concurrently.