What is Tapering
Tapering is the gradual winding down of central bank activities used to improve the conditions for economic growth. This takes place when officials believe that the economy no longer warrants excess stimulus.
BREAKING DOWN Tapering
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).
How Tapering Works
Central banks can employ a variety of policies to improve growth, and they 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, it may lead to high inflation.
Tapering is best known in the context of the Federal Reserve’s quantitative easing program. The program involved a large-scale bond-buying program that aimed to support struggling economic conditions.
Quantitative Easing and the 2007 Financial Crisis
In reaction to the 2007 financial crisis, the Federal Reserve began to purchase assets with long maturities to lower long-term interest rates. This activity was undertaken to entice financial institutions to lend money, and it began when the Federal Reserve purchased mortgage-backed securities (MBS). In 2013, 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.
Tapering the Quantitative Easing Program
The tapering, or reduction, of the QE program that was instituted in response to the 2007 financial crisis began in 2013. This involved schedule reductions in predetermined amounts through 2013, continuing throughout the majority of 2014. For example, in January 2014, the Federal Reserve announced its intention to reduce the program from $75 billion to $65 billion in February of that same year. Ultimately, the reductions continued until the program concluded in October 2014, as the involved economies were deemed to require less financial stimulus than in prior years.
Tapering in 2017 and the Balance Sheet Reduction
After nearly a decade of accommodative monetary policy that saw the Fed's balance sheet balloon to $4.5 trillion, the Fed announced that in October the unwind would begin. The tapering would start at $6 billion a month for Treasuries and $4 billion for MBS. The tapering 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 is expected to fall below $3 trillion in 2020.
Philosophy Behind Tapering
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 loosen 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.