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

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

The prevailing view is that it is the size of the central bank balance sheet that matters most, with studies suggesting that the Fed’s stock of QE purchases has reduced long-term US yields by around two percentage points. Moreover, with longer-term US Treasury yields trading over one percentage point higher than their equivalents in the eurozone and Japan 9, demand from overseas investors is likely to help keep a lid on US yields during the coming months. Although bond yields appear too low relative to the strength of the economy, several factors are likely to work against a sharp rise as the Fed dials back its purchases during the coming months.

  1. Let us briefly examine how the economy and markets reacted to the two tapers in 2013 and 2021, respectively.
  2. When central banks pursue an expansionary policy to stimulate an economy in a recession, they promise to reverse their stimulatory policies once the economy has recovered.
  3. Central banks can hesitate to pull back on their QE policies due to “taper tantrums,” where investors and financial markets overreact to a reduction in stimulus from the central bank.
  4. In the case of quantitative easing, the central bank would announce its plans to slow asset purchases and either sell off or allow assets to mature, thus reducing the amount of total central bank assets and the money supply.
  5. 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.

Hence, policymakers are very careful about the timing, pace, and scale of tapering plans. A recent example of tapering can be seen in the US at the Fed after the 2008 global financial crisis. In June 2013, Ben Bernanke, the Federal Reserve Board Chairman at the time, announced that the Fed would begin tapering and reduce the amount of its asset purchases. 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. On the other side, as central banks like the Fed look to taper, the capital markets closely follow when and how the process will look like.

Why is this of concern to investors?

Real (i.e., after inflation) yields could edge higher, but are likely to remain negative. Bernanke’s words, apparently surprising the markets, set off an increase in market interest rates known as the taper tantrum. The bond market pushed 10-year Treasury velocity trade yields up slightly, from 1.94 percent on May 21 to 2.03 percent on May 22, 2013. 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.

In the weeks after Bernanke’s Congressional testimony, the US stock markets experienced some volatility, with the VIX index, also known as the “fear gauge,” soaring in June 2013. Former Fed Chair Ben Bernanke disclosed the Fed’s intent to slow down asset purchases on May 22, 2013, without any prewarn. Let us briefly examine how the economy and markets reacted to the two tapers in 2013 and 2021, respectively. Inflation has been rising, with the all items version of the Consumer Price Index For All Urban Consumers (CPI-U) recording a 6.2% increase during the 12 months through October 2021, up from 5.4% for the 12 months through September 2021. As a result of QE, the value of bonds held on the Fed’s balance sheet has skyrocketed from $870 billion in August 2007 to $4.2 trillion entering March 2020 and to $8.5 trillion in October 2021. The reason the Fed has decided to accelerate the process is likely because it now believes inflation may be less transitory than it had hoped, at the same time that the labor market appears strong.

Economic commentary: What is tapering and how could it impact financial markets?

Central banks can hesitate to pull back on their QE policies due to “taper tantrums,” where investors and financial markets overreact to a reduction in stimulus from the central bank. In the case of quantitative easing, the central bank would announce its plans to slow asset purchases and either sell off or allow assets to mature, thus reducing the amount of total central bank assets and the money supply. Tapering modifies a central bank’s monetary expansion policies initiated to stimulate an economy. During a program of quantitative easing, a nation’s central bank may buy asset-backed securities from its member banks, injecting money into the economy, to boost recovery. As a result, US goods and services became expensive, which weighed on emerging markets because they had already accrued dollar-denominated foreign debt to cover their trade deficits.

When did the Fed stop tapering?

Tapering is a term used in finance to describe a reduction of monetary stimulus provided by central authorities to the capital markets. However, the Fed did say that in the “longer run,” it plans to hold primarily Treasury securities rather than mortgage-backed securities, because it seeks to minimize its role in allocating credit to different sectors of the economy. Quantitative easing helps the economy by reducing long-term interest rates (making business and mortgage borrowing cheaper) and by signaling the Fed’s intention to keep using monetary policy to support the economy. The Fed turns to QE when short-term interest rates fall nearly to zero and the economy still needs help. As 2013 drew to a close, the Federal Reserve Board concluded that QE, which had increased the Fed’s balance sheet to $4.5 trillion, had achieved its intended goal, and it was time for tapering to commence. The process of tapering would involve making smaller bond purchases through October 2014.

All else being equal, lower purchases of bonds by the Fed should put downward pressure on bond prices and raise yields (the yield of a bond moves inversely with its price). Long-term bond yields are determined by a range of factors, including expectations for growth, inflation and the path of interest rates. This ‘decoupling’ of tapering and the timing of rate hikes is one reason why this year’s market reaction to the prospect of reduced bond purchases has been relatively muted.

In March 2020, restrictions due to the COVID-19 pandemic had major repercussions both for the U.S. economy and the financial markets. To maintain financial stability, the central bank announced a slew of measures on March 23, 2020, including purchasing bonds. From June 2020 until November 2021, the Fed purchased, on average, $80 billion in U.S. The yield on the avatrade broker 10-year US Treasury bond has risen markedly from the pandemic lows of around 0.6%. However, this has largely been due to the upturn in economic growth and inflation over the last year or so. Since the Fed started talking about tapering over the summer, the US 10-year yield has traded in a relatively tight range of 1.2% to 1.6% (the current level is 1.59%) 5.

In turn, elevated asset prices are in part justified by the assumption that long-term bond yields will remain low for an extended period. Investors are concerned that the withdrawal of QE could result in a reduction in liquidity and/or a rise in bond yields which could trigger falls in equity markets. Recent surveys of global fund managers cite a repeat of the 2013 ‘taper tantrum’ as a key risk facing financial markets itrader review going forward 3. The taper tantrum refers to an episode which occurred the last time the Fed was conducting an open-ended QE programme, so-called QE3, which ran between September 2012 and October 2014. In May 2013, then Fed Chair Ben Bernanke triggered a period of sharply rising bond yields when he surprised the markets by indicating that the central bank could soon start to wind down its bond purchases.

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