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

Like all economic stimulus programs, QE policies are not intended trade like a stock market wizard to be permanent and after the desired results of an economic stimulus program have been achieved, those policies must be gradually rescinded. If a central bank changes its operations too fast, it can push the economy into a recession. If a central bank never eases its economic stimulus policies, there may be an increase in inflation. Tapering is the period where the stimulus has worked and before an accelerated expansion toward inflation. Many pundits believed that the stock market could follow suit, since the money flowing into the economy from the Fed through bond purchases was also widely understood to be supporting stock prices.

Inflation

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 in asset purchases would be gradual and that an increase in the Fed’s target for short-term rates was not imminent. To understand how tapering works requires a deeper understanding of quantitative easing. When central banks keep short-term interest rates low, it encourages individual borrowers and businesses to take out loans.

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

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. In response to the global financial crisis, the Fed began purchasing Treasury securities and mortgage-backed securities in 2009. The third, launched in September 2012, was open-ended; the Fed said it would keep buying bonds until labor market conditions improved. 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. Rather than $15 billion, the Fed will reduce purchases by $30 billion every month.

U.S. interest rates already were at historic lows, near zero, before the Fed began its latest surge in bond purchases in response to the pandemic, thereby doubling the size of its massive balance sheet. The tapering announced on Nov. 3, 2021, will continue to add to the balance sheet and thus seems “accommodative” and consistent with a goal of keeping interest rates roughly stable. Indications that the Fed is beginning to taper can produce significant changes in prices for stocks and other assets.

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. 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 What is a trader the Fed’s bond portfolio by mid-2022. This level of wage and price increase is seen as sustainably supporting a growing economy.

Then in January of 2014, the Fed started tapering by $10bn per month from $85bn to $75bn, with the intent of ending the QE program around the middle of 2014. Stock markets fell, US domestic interest rates rose and risky assets, such as Emerging Market debt and equity weakened. In 2013, Federal Reserve Chair Ben Bernanke announced that the Fed would, at some future date, reduce the volume of its bond purchases. In the period since the 2008 financial crisis the Fed had tripled the size of its balance sheet from around $1 trillion to around $3 trillion by purchasing almost $2 trillion in Treasury bonds and other financial assets to prop up the market. Investors had come to depend on ongoing massive Fed support for asset prices through its ongoing purchases. Treasury yields, resulting from the Federal Reserve’s (Fed) announcement of future tapering of its policy of quantitative easing.

Federal Reserve Tapering and Financial Assets

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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. 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. Tight, or contractionary policy is a course of action by a central bank to slow down economic growth, constrict spending in an economy that is seen to be accelerating too quickly, or curb inflation when it is rising too fast. The Fed tightens monetary policy by raising short-term interest rates through policy changes to the discount rate, also known as the federal funds rate. The Fed may also sell assets on the central bank’s balance sheet to the market through open market operations (OMO). Tapering refers to the period of reversal between expansionary policy and contractionary monetary policy.

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. The Fed again adopted this policy in March 2020 after the COVID-19 pandemic resulted in a national lockdown. By November 2021, the Fed had bought over US$4 trillion worth of Treasurys and other securities.

How will tapering influence long-term interest rates?

However, such purchases have led to bloated balance sheets for the central banks that have undertaken QE. At its height, the Fed was spending about $120bn each month, mostly purchasing US Treasury Securities and Mortgage-Backed Securities (“MBS)”. Hence, as central banks look to start tapering, they gold trading silver trading palladium and platinum trading must send the right signals to investors and the markets in order to set market expectations and reduce uncertainty. When they have achieved their goal of economic recovery, central banks will gradually “taper” or scale back their asset purchases.

If inflation rises too much above 2%, and unemployment isn’t excessive, the Fed has two main tools it uses to nudge the economy back into the desired balance. The Fed always owns a sizable quantity of securities and is often buying more at a rate of tens of billions of dollars a month. Buying securities in this fashion injects more newly printed money into the system and is known as monetary stimulus.

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Tapering, which gradually reduces the amount of money the Fed pumps into the economy, should theoretically incrementally reduce the economy’s reliance on that money and allow the Fed to remove itself as the economy’s crutch. 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. That was followed by Operation Twist, where the Fed bought longer-term assets while selling shorter-term securities.

1. The extreme bond market reaction at the time to a mere possibility of less support in the future underscored the degree to which bond markets had become addicted to Fed stimulus.
2. Once investors realized that there was no reason to panic, the stock market leveled out.
3. As with any reduction in demand, with reduced Fed purchases (bond) prices would fall.
4. 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.

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. In response to a question, Powell acknowledged that the announced tapering is “earlier and faster” than most observers had anticipated six months ago. The reason, he elaborated, is that the pace of economic recovery has been stronger than expected, with the U.S. economy having expanded by 6.5% in the first half of 2021, accompanied by a strong job market in which openings are still going unfilled.