What is Tapering?

Tapering is the gradual reversal of a quantitative easing policy implemented by a central bank to stimulate economic growth. As is the case with most, if not all, economic stimulus programs, they are meant to be unwound once officials are confident that the desired outcome, usually self sustaining economic growth, has been achieved.

Key Takeaways

  • Tapering is the gradual reversal of a quantitative easing policy implemented by a central bank to stimulate economic growth.
  • Tapering refers to the reduction, not the elimination, of Fed asset purchases.
  • Tapering prematurely can lead to a recession while delaying it could lead to an unwelcome rise in inflation.

Understanding Tapering

Tapering can only become reality if some type of stimulus program has already been executed. The most recent example was the quantitative easing (QE) program implemented by the U.S. Federal Reserve System (FRS), colloquially known as the Fed, in reaction to the 2007-08 financial crisis.

Tapering activities are primarily aimed at interest rates and at the management of investor expectations regarding what those rates will be in the future. These can include changes to conventional central bank activities, such as adjusting the discount rate or reserve requirements, or more unconventional ones, such as quantitative easing (QE).

QE expands the Fed's balance sheet by buying bonds and other financial assets with long maturities. These purchases reduce the available supply, resulting in higher prices and lower yields (long-term interest rates). Lower yields lower the cost of borrowing which should make it easier for businesses to finance new projects which raises employment leading to an increase in consumption and economic growth. Essentially, it is a monetary policy tool in the Fed's toolbox to stimulate the economy that will be rescinded gradually, or tapered, once the objective has been met.

Tapering came to the fore in 2013 when, then Fed chairman, Ben Bernanke commented that the Federal Reserve would lower the amount of assets purchased each month if economic conditions, such as inflation and unemployment were favorable. A key point to note is that tapering refers to the reduction, not the elimination, of Fed asset purchases.

As 2013 drew to a close, the august body concluded that QE, which had ballooned the Fed's balance sheet to $4.5 trillion, had achieved it's intended goal and that the time to commence tapering was at hand. The process involved scheduled reductions in predetermined amounts through it's conclusion in October 2014. For example, in January 2014, the Fed announced its intention to reduce the program from $75 billion to $65 billion in February of that same year.

Tapering would start at $6 billion a month for Treasuries and $4 billion for MBS. The process would be capped at $30 billion for Treasuries and $20 billion for MBS, meaning that once these levels were reached, additional payments would be reinvested. At this pace, the balance sheet was expected to fall below $3 trillion by 2020. This was further amended in March 2019 when it was announced that, beginning in May 2019, the Treasury amount will fall to $15 billion.

Philosophy Behind Tapering

Central banks can employ a variety of policies to improve growth and must balance short-term improvements in the economy with longer-term market expectations. If the central bank tapers its activities too quickly, it may send the economy into a recession. If it does not taper its activities, then an unwelcome increase in inflation might be in the offing.

Being open with investors regarding future bank activities helps set market expectations. This is why central banks typically employ a gradual taper rather than an abrupt halt to loose monetary policies. Central banks reduce market uncertainty by outlining their approach to tapering, and by specifying under what conditions that tapering will either continue or discontinue. In this regard, any foreseen reductions are spoken of in advance, allowing the market to begin making adjustments prior to the activity actually taking place.