Tapering: How, Why, and When the Fed Does It and Impact on Financial Markets

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. Tapering is initiated after the quantitative easing policies have stabilized an economy https://www.investorynews.com/ and may include changing the discount rate or reserve requirements. Tapering not only means the end of the central banks’ expansionary policies, it also signals the eventual onset of monetary tightening. That, for one, means higher interest rates on mortgages, consumer loans, and business borrowing.

Tapering does not involve selling the securities that the central bank purchased; it’s merely winding down the pace at which those securities are bought. 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 fact, the S&P 500 has performed better in the wake of Fed decisions to raise the Fed funds rate than in the wake of rate cuts, on average,” he finds. Inflation has been rising, with the all items version of the Consumer Price Index For All Urban Consumers (CPI-U) recording a 6.2% increase during the 12 months through October 2021, up from 5.4% for the 12 months through September 2021. As a result of QE, the value of bonds held on the Fed’s balance sheet has skyrocketed from $870 billion in August 2007 to $4.2 trillion entering March 2020 and to $8.5 trillion in October 2021. Americans have enjoyed rock-bottom interest rates for the better part of the past 13 years, helping to make it cheaper to borrow money to buy cars and homes and start businesses.

Tapering refers to the Federal Reserve policy of unwinding the massive purchases of Treasury bonds and mortgage-backed securities it’s been making to shore up the economy during the pandemic. Tapering can impact debt markets and can have a ripple effect on U.S. and emerging market stocks. However, the extent of that impact can vary depending on whether the markets are expecting the taper or if it comes as a surprise. For several months, Federal Reserve Board (FRB) Chair Jerome Powell has signaled a growing consensus among members of the Federal Open Market Committee (FOMC) that they should begin tapering purchases of bonds downward from $120 billion per month. At some point after tapering is complete, the Fed is planning to gradually reduce the size of its balance sheet by letting maturing securities “run off” the balance sheet without replacing them, as it did from October 2017 until September 2019. On Nov. 3, 2021, Powell announced that the Fed’s monthly purchases would decline to $105 billion in December 2021, with further reductions leading to an eventual goal of zero net additions to the Fed’s bond portfolio by mid-2022.

The bond market pushed 10-year Treasury yields up slightly, from 1.94 percent on May 21 to 2.03 percent on May 22, 2013. Following the June FOMC meeting, Bernanke elaborated on the plan for tapering, and yields rose more substantially, eventually hitting 2.96 percent on September 10. This occurred despite efforts by Bernanke and other FOMC members to emphasize that any reduction https://www.day-trading.info/ in asset purchases would be gradual and that an increase in the Fed’s target for short-term rates was not imminent. By buying U.S. government debt and mortgage-backed securities, the Fed reduces the supply of these bonds in the broader market. Private investors who desire to hold these securities will then bid up the prices of the remaining supply, lowering their yield.

The Consumer Price Index, which includes several categories of everyday items that a typical American might buy, is the measure of inflation most often reported in the media. The foremost reason is that the markets expected the taper that began in November 2021, so a knee-jerk reaction as seen in 2013 didn’t occur. “Substantial further progress” indicates progress made toward maximum employment and price stability, and is how the Fed gauges when to begin the taper. As a result of the years-long stimulus, the Fed’s balance sheet increased from $862 billion in August 2007 to $4.52 trillion by January 2015. Consumers and companies are already beginning to see slightly higher rates on mortgages, business loans and other types of borrowing. The Fed again adopted this policy in March 2020 after the COVID-19 pandemic resulted in a national lockdown.

What is the Fed taper? An economist explains how the Federal Reserve withdraws stimulus from the economy

However, long-term rates also reflect market expectations about the course of short-term rates. Since tapering can signal to markets that the Fed is shifting to a less accommodative policy stance in the future, this could lead to a rise in long-term rates, as occurred during the taper tantrum. Tapering can impact long-term interest rates through both its direct effects on bond markets and the signal it provides about the Fed’s future policy intentions. Quantitative easing helps the economy by reducing long-term interest rates (making business and mortgage borrowing cheaper) and by signaling the Fed’s intention to keep using monetary policy to support the economy. The Fed turns to QE when short-term interest rates fall nearly to zero and the economy still needs help. 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.

In a subsequent press conference, Powell said that tapering would be concluded by the middle of 2022. The Fed stuck to that timeline, stopped its asset purchases concluding the taper by March 2022. 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. Hulbert notes that the Fed traditionally seeks to raise interest rates amid a booming economy to keep it from overheating. In either case, the upshot of his analysis is that economic fundamentals other than interest rates tend to have a bigger impact on stock prices. During his press conference on Nov. 3, 2021, Fed Chair Powell insisted that, despite tapering, the Fed’s stance will remain “accommodative,” still seeking to keep interest rates near zero.

In December 2013, the Fed began to taper, reducing the pace of asset purchases from $85 billion per month to $75 billion per month. Purchases were reduced by a further $10 billion at each subsequent meeting (in February 2014, Janet Yellen took over as Fed Chair). The asset purchase program ended in October 2014, and the Fed began shrinking the balance sheet in October 2017. The U.S. central bank began tapering in November 2021, scaling back total purchases by $15 billion a month, from $120 billion to $105 billion.

Tapering to Reduce Inflation

On the other side, as central banks like the Fed look to taper, the capital markets closely follow when and how the process will look like. In the US, Federal Reserve Board Chairman Jerome Powell indicated in August 2021 that the Fed is likely to begin tapering before the end of 2021 as part of his annual Jackson Hole speech. Bond purchases can impact market expectations about the future path of monetary policy. QE is seen as a signal from the Fed that it intends to keep interest rates low for some time.

1. Tapering not only means the end of the central banks’ expansionary policies, it also signals the eventual onset of monetary tightening.
2. When the Fed began aggressively buying assets in 2020 to help soften the financial impact of the COVID-19 pandemic, it marked a pause in its tapering of asset purchases.
3. Bond purchases can impact market expectations about the future path of monetary policy.
4. So tapering not only reduces the amount of QE, it is also seen as a forewarning of tighter monetary policy to come, as was observed in the aftermath of the Great Recession.

He described the balance sheet shrinkage as a process that would be “running in the background” alongside the Fed’s rate hikes. While monetary tightening, such as through tapering, is a possible policy lever to rein in inflation, Powell has indicated that the Fed sees transitory factors such as temporary “supply bottlenecks” as the main drivers of recent price hikes. As a result, he has warned that monetary tightening in hopes of curbing inflation actually may hurt economic growth and employment in the longer https://www.topforexnews.org/ term while having little impact on future price increases. Since the prices of financial assets—particularly debt instruments such as bonds, but also stocks—tend to be inversely related to interest rates, critics of QE worry that it has created asset price bubbles. Hard assets such as real estate also may have been caught in speculative bubbles, driven by low borrowing rates and low returns on financial assets. Likewise, the rising flow of funds into cryptocurrencies may be yet another consequence of QE.

But with its target rate at zero during the 2008 crisis – at the same time that there was no inflation and the economy was still hurting – the Fed was no longer able to cut rates further. And so the Fed turned to quantitative easing as a way to continue to reduce borrowing costs. When the government buys assets, their prices go up, which lowers their yield or interest rate. 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. Fed tapering introduces uncertainty to the market, a departure from the Fed’s steady asset purchases.

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. 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.

What happens after the Fed stops buying Treasury and mortgage-backed securities?

That was followed by Operation Twist, where the Fed bought longer-term assets while selling shorter-term securities. The last leg of large-scale asset purchases lasted from September 2012 until 2014, totaling $790 billion in Treasury securities and $823 billion in agency MBS. The Fed’s motivation for tapering is to slowly remove the monetary stimulus it has been providing the economy. Specifically, according to guidance the Fed issued in December 2020, tapering was to begin once the economy had made “substantial further progress” toward its goals of maximum employment and price stability.

What does the Federal Reserve mean when it talks about tapering?

When they have achieved their goal of economic recovery, central banks will gradually “taper” or scale back their asset purchases. Tapering impacts the supply of such securities and can move not just the bond markets in the U.S. but also stock markets around the globe. Central banks, such as the U.S.Federal Reserve (Fed), can stimulate economic recovery by buying asset-backed securities. This process, along with maintaining a low interest rate, is called “quantitative easing (QE).” But central banks can’t endlessly purchase securities and pump money into the economy. When they believe the economy has recovered sufficiently, they work on winding down asset purchases or “tapering.” While the reduction in asset purchases will have a direct impact on the prices or yields of those assets, the bigger implication is what it signifies for the timing of the Federal Reserve hiking policy rates.

Tapering would gradually slow down an unprecedented program of quantitative easing (QE) that has sent interest rates down to near zero, mainly through massive purchases of bonds by the Fed. QE initially was adopted as a policy response designed to prop up the economy and the securities markets in the wake of the financial crisis of 2008. Normally, when a central bank wants to reduce the cost of borrowing for companies and consumers, it lowers its target short-term interest rate.