Fed tapering: what does tapering mean and how will it impact markets?

What is tapering?

Tapering is the reduction of the rate at which a central bank buys new assets. It’s most commonly used when talking about the reversal of quantitative easing (QE) policies and is regarded as the first step in winding down from a period of monetary stimulus. Tapering is just another tool used by central banks to control interest rates and the perception of future rates.

QE programmes are put in place by central banks to stimulate economic growth. Once the desired targets have been met, a bank will start to reduce its acquisition of assets. Banks have to taper their spending because continuing expansionary policies can lead to over-inflation and bubbles.

For example, up until August 2021, the US government was buying $120 billion worth of assets each month in a bid to aid the recovery from the coronavirus pandemic – a program it had started in March 2020. When the US government starts to reduce the value of assets it buys, say from $120 billion to $100 billion, that would be the start of QE tapering. 

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Tapering vs tightening

Tapering is not to be confused with tightening. When a central bank tapers its quantitative easing program, it reduces the value of assets that it’s buying each month. When a central bank tightens its quantitative easing program, it will no longer add any assets to its balance sheet and will instead reduce the assets it holds by selling them instead.

What impact does tapering have?

Tapering impacts interest rates almost immediately. QE policies lower the interest rate, so when the purchasing program is reduced, interest rates will rise again.

Tapering leads to deflation, pulling money out of the system and making the cost of living more affordable but increases unemployment. When the money supply is limited, lenders tend to be more restrictive over who they will lend money out to and choose those that offer the highest interest rates. This selective borrowing leads to competition that can send rates rocketing.

What is the impact of tapering on markets?

Tapering often leads to ‘taper tantrums’, which is the name given to the collective panic that follows the central bank reducing its QE program. As central banks start to buy up fewer assets, fears that liquidity would decline cause investors to fear the global market could crumble.

A taper tantrum often plays out across bond prices. And when bond prices fall, bond yields rise. There’s always the potential that shares and indices could follow, since the bond market is believed to support stocks. However, in previous tapering scenarios, this has never actually happened.

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Let’s look at an example of when tapering impacted financial markets.

Examples of tapering

Tapering was first coined in May 2013, when the US Fed Chairman at the time – Ben Bernanke – stated they’d be reducing the QE program that had been in place following the 2008 financial crash. The aim was to encourage bank lending again and stimulate the economy by purchasing bonds with long maturities and mortgage-backed securities.

Once the impact on inflation had been achieved, it announced it would buy fewer and fewer assets each month in a bid to taper its program.

The statements made by the Fed caused a ripple of concern throughout financial markets as the expectation was that the reduction in QE would be unfavourable for stocks and bonds. Bond markets did sell off quite quickly in the wake of the tapering comments, and stocks started to show volatility but they both quickly stabilised. Ever since, tapering has caused less fear for investors, however it does still have an impact.

Fed tapering program 2021

In August 2021, expectations that the Federal Reserve would start to taper its buying of assets caused a taper tantrum in which commodities and global shares fell – the FTSE 100 dropped by 1.5%.

After recovery from the Covid-19 pandemic caused stock markets across the world to rally, news that US monetary policy could start to pull back led to fears that optimism had peaked. However, the tantrum only lasted a day as markets waited to see what the next monetary policy meeting had in store.