Author: Drishti Dhakan, Investment Analyst at Xanara
The financial world is often recognized for inventing new definitions for old words, and then constantly referring to these new terms as if everyone should know what they mean.
One such recent terminology is “tapering”.
The “tapering” terminology entered the financial vocabulary on May 22, 2013, when U.S. Federal Reserve Chairman Ben Bernanke declared in his statement before Congress that the Fed may taper, or reduce, the size of its bond-buying program known as quantitative easing (QE).
Circa the great financial crisis, central banks had been printing money to purchase assets such as government bonds. This is known as “quantitative easing”, or QE. One of the objectives of QE is to reduce the cost of borrowing across the entire economy. The idea behind QE is that it helps the economy by reducing interest rates and making corporate borrowing and mortgages cheaper. By buying government debt and Mortgage-Backed Securities, the central bank reduces these instruments’ supply in the broader market.
Investors who decide to hold these instruments need to raise their bids, pushing yields down. This makes it cheaper for those with debts to pay their interest bills but also make it more attractive for companies to borrow money to invest in expanding their businesses. This in turn helps in boosting economic growth.
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Another side effect of QE has been that it pushes asset prices higher, from equities to bonds to property prices. The investors are happy and consider this a good omen when central banks add more QE but are often taken aback when they reduce it.
“Tapering” signifies a gradual slowing of the pace of the Federal Reserve’s large-scale asset purchases. Tapering does not refer to an outright reduction of the Fed’s balance sheet, but only to a reduction in the pace of its expansion. For instance, at the present moment, the US government is buying $120 billion worth assets on a monthly basis.
If the US government were to drop the asset purchases from $120 billion to $100 billion the next month, that would be signified as tapering. At some point after tapering is complete, the central bank can be likely to gradually reduce the size of its balance sheet by letting maturing securities “run off” the balance sheet without replacing them.
Historically markets didn’t like this idea, fearing that less QE would push asset prices lower. 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. The combination of projected reductions in asset purchases and the possibility of higher rates in 2013 led to a period of high volatility and rising rates in the bond market—an episode that became known as the taper tantrum.
Impacts of Fed Tapering
The impacts of Fed tapering can be:
1. Interest Rates
Primarily the impact of tapering can be seen on interest rates. QE is generally used when the interest rates are already at zero level and the Central Bank wants to provide even more stimulus. Hence, when tapering is adopted, it is expected to send the interest rates shooting. This is because a limited money supply means lenders will have to be selective about their lending. They will prefer to lend out money to those who can offer the highest interest rates and this can send the interest rates appreciating.
2. Inflationary
QE is inflationary. This is because it simply increases the monetary base in the economy. Therefore, when there is more money available and it is chasing relatively fewer goods, inflation occurs and prices appreciate. Hence, when tapering is implemented, the inflation is likely to turn into deflation. This is because tapering pulls money out of the system. Hence there is now less money (as compared to before) chasing the goods available, making goods comparatively less expensive.
3. Impact on Economy
The money supply in the economy is interlinked to its asset prices. As the money supply increases, everybody in the economy has more purchasing power and asset prices tend to go up. However, when money supply decreases, the reverse happens and asset prices tend to deflate. The Fed has unnaturally inflated the dollar supply by producing money and buying assets from the market. Currently, this is an ongoing policy and when the Fed decides to stop doing this, the money supply will fall causing the asset markets to contract.
The most recent FOMC meeting took place on 22nd of September 2021 where the Federal Reserve Chairman Jerome Powell put out a statement that “If progress continues, a moderation of the pace of asset purchases can be warranted,”. He added, “Policy will remain accommodative until we achieve maximum employment and price stability goals.” While nothing was decided at this meeting, he indicated that “a gradual tapering process that concludes around the middle of next year can be appropriate.”
As seen on several occasions earlier as well as on 22nd of September, the supporting factor is that the Fed always likes to signal its intentions around tapering its QE program well in advance to minimize the impact on the markets. Although in the past, the anticipation of tapering has unsettled markets, we can expect it to be more orderly this time, as the markets have been through the experience before. Still, it’s important for us to understand the process.