What exactly does tapering mean? Why do central banks reduce QE and monetary policy stimulus? What are the consequences for the economy and inflation?
The term tapering refers to a monetary policy tool adopted by central banks and coined quite recently.
Its first appearance in the financial vocabulary, in fact, dates back to 2013, when the then president of the Fed, Ben Bernanke, used this very word to announce a “thinning” of the quantity of government bonds to be purchased according to an expansionary monetary policy plan and to stimulate demand and growth implemented up to that point.
Tapering has thus become a technical expression to indicate a specific strategy of central banks: that of starting a easing of massive bond purchases previously established in contexts of economic weakness.
It is no coincidence that tapering has returned to the forefront after the boom in government bond purchases by the Fed and the ECB following the serious crisis triggered by the pandemic in 2020. In 2021, Lagarde and Powell began to reduce the amount of bonds purchased on the markets precisely to recalibrate financial balances in a situation that was no longer an emergency. Analysts began to talk about tapering to describe this change in monetary direction.
The most recent economic history has once again upset the central bank’s plans. Since 2022, in fact, the word tapering has been set aside to make room for a sudden increase in interest rates and a more moderate bond-buying policy in the face of inflation that has soared to record levels with the war in Ukraine and the energy crisis.
However, considering the leading role played by the Fed and the ECB in global finance in recent years, knowing what is tapering, its definition and the consequences of its use is highly topical.
What is tapering? Definition and meaning
The term tapering indicates a reduction of extraordinary measures of expansionary monetary policy implemented by central banks.
The first to explain the meaning of tapering, as we anticipated, was the American central bank, when in 2013 it began to reduce large-scale purchases of government bonds, the QE program, which began in 2008 with the subprime mortgage crisis.
To understand in detail what is meant by tapering, it is also important to have a clear definition of Quantitative Easing, given that this progressive thinning is applied precisely to QE measures.
Quantitative Easing refers to the decision of the central bank, such as the ECB, to create debt money (by purchasing government debt) and inject it into the financial and economic system with the intent of spreading the confidence of operators and promoting liquidity and loans
Tapering is nothing other than the gradual reduction of this liquidity injection to rebalance the market and avoid too much money being injected into the system with the risk of a surge in inflation (stimulated by the strong demand for investments, loans and consumption in general).
How does tapering work?
“Tapering goes hand in hand with recovery: it is the slowing down of the pace of asset purchases decided by central banks to support economies in crisis”: in this definition developed by ING analysts, we can also extrapolate the meaning of the functioning of this instrument.
In practice, after having activated plans to stimulate a stagnant or crisis-ridden economy (as happened in the pandemic era) through Quantitative Easing, the central bank decides to gradually reduce this push for investment and recovery.
To do so, it announces tapering: the purchase of government bonds that has characterized monetary policy up to now is reduced. Be careful, we are talking about reduction and not interruption. The meaning of tapering is precisely this: to reduce the amount of liquidity in the market - but not to stop it abruptly - with a scaled-down bond purchase plan.
In fact, given a country in economic recovery, with demand and investments recovering, continuing to inject large amounts of money could be counterproductive and drive up prices.
In short, the function of tapering is to normalize monetary policy which had to intervene with ad hoc tools (Quantitative Eaasing) to relieve a crisis situation.
Graduality is crucial for tapering to work properly.
As we know, central banks can use a series of policies to improve growth, but they must balance short-term progress with long-term market expectations. If the central bank concludes its stimulus measures too quickly, it can also push the economy into recession. But if it delays concluding the stimulus, inflation rises above the hoped-for levels, with the need to intervene as happened from mid-2022 onwards (with record interest rates).
Tapering and the impact on the markets
The gradual nature of tapering goes hand in hand with caution in its official announcement. If, in fact, a central bank declares that the expansionary monetary policy and the injection of liquidity into the economic system is about to end, the reaction of the markets could be explosive.
It is no coincidence that history remembers how the Fed in 2013 gave rise to financial panic, stating that bond purchases would soon decrease. The phenomenon is known as “taper tantrum” (translatable as sudden unleashed anger) and is a nightmare for investors. At the time, there was a jump in Treasury yields, with a depreciation of their value and a panic-inducing outflow of capital.
Investors, accustomed to massive doses of liquidity thanks to the expansionary policy introduced by the Fed, found themselves disoriented by the possibility of a change and began to sell bonds, whose value was subjected to strong downward pressure.
Tapering, in fact, anticipates what will happen shortly in economics and finance, namely the central bank’s lower propensity to purchase bonds. With less demand to support the supply of government bonds, the latter will see a decrease in price and consequently an increase in yield.
Markets could be shaken by this change in strategy that heralds a shift from easy access to credit to more restrictive conditions.
Tapering and tightening: differences
Be careful not to confuse or combine these two terms: tapering and tightening. Both expressions refer to decisions by central banks, but are used to define different intervention strategies.
The word used alone, therefore, refers to the moves of restrictive monetary policy and concerning the cost of money. In contexts of high inflation, as happened following the war in Ukraine, the Fed and the ECB have opted for a very significant increase in the interest rate, to discourage demand, consumption, investments and therefore cool the economy and prices.
If, then, the term goes to compose the phrase Quantitative Tightening, it means a reduction in the amount of liquidity injected into the financial system. In essence, when a government bond purchased by the central bank expires, the reimbursement is not used to buy new bonds. All this, in a more decisive and clear way than tapering.
The History of Tapering, Between the Fed and the ECB
In response to the 2008 financial crisis, the Federal Reserve began buying assets with long maturities to lower long-term interest rates.
This activity was done in order to entice financial institutions to lend money to the public and began when the Federal Reserve bought mortgage-backed securities. In 2013, Ben Bernanke announced at a conference that the Federal Reserve would lower the amount of assets it purchased each month if economic conditions, such as inflation and unemployment, remained favorable.
The tapering of the QE program in the United States, instituted in response to the 2008 financial crisis, began in 2013 and continued through most of 2014.
In January 2014, the Federal Reserve announced plans to reduce the program from a monthly amount of $75 billion to $65 billion the following month. The cuts continued until the program ended in October 2014.
Then, in mid-September 2019, the Fed injected new liquidity to lower Treasury yields, with a program of purchasing 60 billion in securities per month that was maintained until mid-2020.
As for the ECB, it is relevant to remember that since March 2022 the Eurozone central bank has started tapering, ending net purchases of bonds with the PEPP, while the maturing principal of the purchased securities will be reinvested at least until the end of 2024.
The PEPP was created with the outbreak of the pandemic, to help “people and businesses to obtain the funds they need to face the crisis at an affordable cost.”
Original article published on Money.it Italy. Original title: Cos’è il tapering? Significato ed effetti dello strumento di politica monetaria
