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Tapering is an important economic process, even though the term can be rather complicated. Let’s try to figure it out.
What is tapering?
Tapering is a term that finally entered the financial lexicon on May 22, 2013, when Fed Chairman Bernanke told Congress that the Fed could taper its asset buyback program in the coming months.
Tapering is the gradual renouncement of the central bank's quantitative easing strategy aimed at accelerating economic growth. It can only happen if some sort of stimulus program has already been tried.
In times of economic crisis, the Federal Reserve may start a process known as quantitative easing (QE). It buys massive amounts of government bonds and mortgage-backed securities to increase the money supply, encourage lending, and decrease interest rates in order to stimulate lagging economy. When it finally recovers, the Fed may gradually begin to stop these purchases and raise interest rates to allow the economy to restabilize. This is the process of tapering.
How does tapering affect?
The Fed has two notable ways to stimulate the economy: lowering the Federal Funds rate and large-scale asset purchasing, primarily fixed income securities (also called quantitative easing). These instruments help lower short-term and long-term interest rates, respectively, to make borrowing money cheap. The hope is that this cheaper money will stimulate spending and stimulate the economy.
Fed buying bonds is a way to lower long-term interest rates. As the Fed buys more bonds, there are fewer bonds left in the market. This will lead to an increase in the value of existing bonds. Since the price of bonds and interest rates are inversely related, this leads to lower long-term interest rates.
In addition to lowering interest rates, QE also increases the money supply in the economy, which helps provide liquidity during times of uncertainty. In addition, this policy helps build confidence in the markets as it shows that the Fed is ready to intervene and help during an economic downturn.
Tapering and crises
The quantitative easing policy was implemented after the financial crisis of 2007-2008 and had a good effect on stock and bond prices in the US financial markets. As a result, investors were worried about the impact of tapering this policy.
In 2013, the taper tantrum occurred. People panicked and that caused the US Treasury yields to spike. It happened after investors found out that the Federal Reserve was slowly putting a brake on its quantitative easing (QE) program. The main concern behind the taper tantrum stemmed from fears that the market would collapse because of the end of QE. In the end, the hysterical panic was unjustified as the market continued to recover after the tapering has actually started.
As tapering is a theoretical possibility—in fact, it has never been fully implemented by central banks that have introduced an economic stimulus based on quantitative easing—it’s difficult to say exactly what effect the tapering will have on the stock market. However, analysts have widely believed in the past that once the Fed starts slowly lifting its economic stimulus, the stock market will react negatively.
During the COVID-19 outbreak, the Fed's actions were aimed at restoring the smooth functioning of the Treasury and Mortgage-backed Securities (MBS) markets. In March 2020, the Fed shifted its QE target to support the economy. It said it would buy at least $500 billion in Treasury securities and $200 billion in government-guaranteed MBS "over the coming months." On March 23, 2020, the Fed made the purchases perpetual, stating that it would purchase securities "in the quantities necessary to ensure the smooth functioning of the market and the effective transfer of the monetary policy to broader financial terms". It expanded the stated purpose of the bond purchases to include supporting the economy.
In November 2021, deeming that the test had passed, the Fed began reducing its asset purchase rate by $10 billion in Treasuries and $5 billion in MBS each month. At the subsequent FOMC meeting, the Fed doubled the rate of this cut.
Tapering and its market impact
Surprisingly, tapering affected various markets differently. We’ll discuss two of the most important for us, which occurred during the crisis in 2013.
The US stock markets experienced some volatility in the weeks to come. The Cboe VIX, often called the "fear indicator", measures expected volatility in the options markets, and it surged in June 2013. Major stocks indices, such as the S&P 500 and Dow Jones, also experienced sell-offs, but bounced back and ended the year up 10.74% and 7.73%, respectively.
US dollar and emerging markets
After the Fed’s announcing the reduction of stimulus as a signal to tighten monetary policy, the US dollar strengthened sharply. When emerging markets run a trade deficit, they often accumulate dollar-denominated external debt to cover the deficit. The announcement of the tapering hit them hard for two reasons: with rising US yields, funding emerging markets became more difficult as investors reallocated their funds to US debt markets; and emerging market currencies depreciated against the dollar, making US goods and services expensive to buy, increasing pressure on the balance of payments. The result was stock market turmoil and monetary tightening in many emerging markets.
2022-09-19 • Updated