Tapering

Tapering is the central bank's reduction or gradual scaling back of monetary policy stimulus or asset purchase program. It aims to decrease the pace of economic growth and prevent inflationary pressures. When a central bank employs this process, it reverses its ongoing quantitative easing programs.

Central banks attempt to gradually wean the financial system and the economy off the stimulus measures put in place during periods of economic weakness through tapering. Moreover, it is an essential tool for the central banks to manage the economy and maintain stability. However, it may lead to market volatility and economic instability if improperly executed.

• Tapering is a financial process where the central banks reverse their monetary policy stimulus and asset purchase programs to reduce the economic growth pace and inflationary pressures.
• The central banks reduce their current quantitative easing programs to release the stimulus measures implemented in the financial system during times of economic crisis.
• It helps in maintaining balance in the economy and brings in financial stability. However, poor implementation strategies or execution can result in economic instability and market volatility.

Tapering is the central bank's gradual reversal or reduction in the ongoing monetary policy stimulus or asset purchase programs. It is a valuable instrument for maintaining economic stability. It assists in moderating the speed of the growth in the economy and restricts inflationary pressure.

The central banks often use quantitative easing during periods of economic weakness or financial crisis. It involves purchasing government bonds or other securities from the market, injecting liquidity, and stimulating economic activity. However, as the economy recovers and strengthens, excessive monetary stimulus can lead to inflationary pressures and other risks to financial stability. Therefore, central banks initiate the process of tapering to reduce the level of stimulation gradually.

This process is usually perceived as a positive signal, reflecting confidence in the economy's strength. It indicates that the economy can sustain itself with reduced monetary support. However, if the process is too abrupt, it may lead to market volatility and economic instability. Therefore, it requires careful planning, communication, and execution to maintain stability in financial markets and the economy.

Some fundamental causes that can lead to tapering are:

• Economic Recovery: It often occurs when the economy shows sustained improvement and recovery. As the economic conditions strengthen, central banks may gradually reduce their monetary stimulus measures, like quantitative easing, to prevent excessive inflation and normalize the financial system.
• Inflationary Pressures: If the central bank observes rising inflationary pressures, it may opt for this method to prevent inflation from spiraling out of control. The process reduces the liquidity injection into the economy, which can help decline rising prices and maintain price stability.
• Policy Objectives: The central banks have specific policy objectives, like maintaining price stability and promoting sustainable economic growth. When these objectives are at risk due to excessive stimulus, implementing this method can help bring the economy back to a more sustainable path.
• Financial Stability Concerns: Extended periods of monetary easing can lead to the buildup of financial imbalances and risks. This approach can address these concerns by gradually reducing the support to the financial system, allowing it to adjust and mitigate potential risks.
• Exchange Rate Management: In some cases, the central banks may consider this process as a means to manage exchange rates. Excessive monetary stimulus can put downward pressure on a country's currency, and tapering can help stabilize the exchange rate by reducing liquidity injections and influencing market expectations.

Let us study a few examples to understand this process:

Example #1

Let us assume that a central bank has been conducting a large-scale asset purchase program, also known as quantitative easing, to stimulate the economy. They have been buying government bonds and injecting liquidity into the financial system. The central bank initiates tapering as the economy gradually recovers and inflationary pressures build up. This involves reducing the amount of government bonds purchased each month.

Instead of buying $100 billion worth of bonds per month, the central bank may decrease it to $80 billion. This reduction in bond purchases gradually reduces the level of monetary stimulus in the economy. As a result, the interest rates may begin to rise, borrowing costs for businesses and consumers could increase slightly, and the market might experience some volatility.

Example #2

The Federal Reserve took several actions to contain the economic fallout during the pandemic. This included expansionary policy and quantitative. The Fed has purchased $120 billion monthly since March 2020 to support the US economy. However, tapering the Fed's asset-purchase program in December 2021 was the first significant step towards normalizing the monetary policy.

The Fed initiated the process with monthly asset purchases reduced from $120 billion to $105 billion. Surprisingly, within two weeks, they decided to double the pace of tapering in response to rising inflation and a more robust economic recovery. This is an example of tapering.

Here are some impacts that tapering can have on the economy:

• It can lead to an increase in long-term interest rates. When the central banks reduce their government bonds and other securities purchases, the reduced demand can lower bond prices and increase yields. This, in turn, affects borrowing costs for businesses and consumers, including mortgage rates and corporate borrowing rates.
• This method can influence currency exchange rates. If the central banks reduce their monetary stimulus, it can signify a relatively tighter monetary policy than other countries. This can attract foreign investors seeking higher yields, strengthening the currency.
• The process can impact asset prices, including stocks, bonds, and commodities. Reducing monetary stimulus can create uncertainty and potentially increase volatility in financial markets. Investors may reassess their risk appetite and adjust their portfolios, which can cause fluctuations in asset prices.
• Tapering is often associated with an improving economic scenario. It indicates that the central bank believes the economy is strong enough to withstand a reduction in monetary support. However, if implemented abruptly, it can dampen economic growth and consumer spending.

The differences are as follows:

• Tapering: This is a gradual reduction in the central bank's pace of asset purchases or monetary stimulus. It involves scaling back the number of securities, like government bonds, that the central bank buys as part of its quantitative easing program. This process aims to reduce the stimulus level provided to the economy while maintaining some ongoing support. It is often employed when the economy shows signs of improvement and can withstand a reduction in monetary accommodation.
• Quantitative Tightening: It is also known as balance sheet normalization or asset runoff. It involves actively reducing the size of a central bank's balance sheet. This process occurs when the central bank starts to sell or allows maturing assets on its balance sheet to roll off without reinvesting the proceeds. It effectively removes liquidity from the financial system and reverses the previous asset purchase program. This tool is generally applicable when the central bank seeks to actively shrink its balance sheet and return it to a more normal size after a period of quantitative easing.

This has been a guide to Tapering and its meaning. We compare it with quantitative tightening, explain its causes, examples, and impact. You can learn more about it from the following articles –

• Taper Tantrum
• Fed Balance Sheet
• Quantitative Easing 2