In December, reacting to surging inflation, the Fed decided to double the pace of tapering, which would bring the bond buying to an end in March. 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. Tapering is the first step in the process of either winding down or withdrawing from a monetary stimulus program that has already been executed and deemed successful. Communicating openly with investors regarding the direction of central bank policy and future activities helps to set market expectations and reduce market uncertainty. 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.
Tapering resumed in November 2021, and the asset-purchase program concluded in March 2022. However, long-term rates also reflect market expectations about the course of short-term rates. Since tapering can signal to markets that the Fed is shifting to a less accommodative policy stance in the future, this could lead to a rise in long-term rates, as occurred during the taper tantrum.
Even when short-term rates have fallen to zero, long-term rates often remain above this effective lower bound, providing more space for purchases to stimulate the economy. When they have achieved their goal of economic recovery, central banks will gradually “taper” or scale back their asset purchases. Tapering impacts the supply of such securities and can move not just the bond markets in the U.S. but also stock markets around the globe. Tapering would gradually slow down an unprecedented program of quantitative easing (QE) that has sent interest rates down to near zero, mainly through massive purchases of bonds by the Fed. QE initially was adopted as a policy response designed to prop up the economy and the securities markets in the wake of the financial crisis of 2008.
What’s a Taper, and Why Has the Fed Started Tapering?
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. Fed Chair Powell, a member of the Board of Governors of the Federal Reserve during the earlier taper, said in March 2021 that the central bank would “supply clear communication” well in advance of the actual tapering. At some point after tapering is complete, the Fed is planning to gradually reduce the size of its balance sheet by letting maturing securities “run off” the balance sheet without replacing them, as it did from October 2017 until September 2019.
The Fed’s balance sheet ballooned from $4.3 trillion in March 2020 to over $8.9 trillion by May 2022. The Brookings Institution is a nonprofit organization based in Washington, D.C. Our mission is to conduct in-depth, nonpartisan research to improve policy and governance at local, national, and global levels.
“We are phasing out our purchases more rapidly because with elevated inflation pressures and a rapidly strengthening labor market, the economy no longer needs increasing amounts of policy support,” Powell said Wednesday. “In addition, a quicker conclusion of our asset purchases will better position policy to address the full range of plausible economic https://www.dowjonesrisk.com/ outcomes.” The Fed’s pandemic policies helped stimulate the economy and consumer demand during the height of the crisis, but the U.S. central bank does not have monetary tools to ease the supply constraints. The move to speed up tapering comes as inflation has thrown a new wrench in the Fed’s ability to use its tools to support the economy.
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Specifically, according to guidance the Fed issued in December 2020, tapering was to begin once the economy had made “substantial further progress” toward its goals of maximum employment and price stability. Tapering is the gradual slowing of the pace of the Federal Reserve’s large-scale asset purchases. Tapering does not refer to an outright reduction of the Fed’s balance sheet, only to a reduction in the pace of its expansion. 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.
- In March 2020, restrictions due to the COVID-19 pandemic had major repercussions both for the U.S. economy and the financial markets.
- The Fed is hoping to find a balance between supporting a still-vulnerable economy while containing the inflationary pressures sparked by the pandemic’s ebb.
- The Federal Reserve said in a policy statement Wednesday that it was greatly reducing its massive bond-buying program, a pandemic-era initiative that flushed cash into financial markets and aimed to buoy the economy during the health crisis.
- While the reduction in asset purchases will have a direct impact on the prices or yields of those assets, the bigger implication is what it signifies for the timing of the Federal Reserve hiking policy rates.
- 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.
While the reduction in asset purchases will have a direct impact on the prices or yields of those assets, the bigger implication is what it signifies for the timing of the Federal Reserve hiking policy rates. These tapering announcements have typically resulted in sharp rises in government bond yields, yield curve distortions, and equity market sell-offs. Hence, policymakers are very careful about the timing, pace, and scale of tapering plans. Tapering is shorthand for a gradual end to the massive bond-buying program the Federal Reserve unleashed in early 2020, when the pandemic crashed the economy.
Bloated Balance Sheets For The Central Banks
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. 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. 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. When the Fed began aggressively buying assets in 2020 to help soften the financial impact of the COVID-19 pandemic, it marked a pause in its tapering of asset purchases.
Since the prices of financial assets—particularly debt instruments such as bonds, but also stocks—tend to be inversely related to interest rates, critics of QE worry that it has created asset price bubbles. Hard assets such as real estate also may have been caught in speculative bubbles, driven by low borrowing rates and low returns on financial assets. Likewise, the rising flow of funds into cryptocurrencies may be yet another consequence of QE. Should tapering actually push interest rates significantly higher, it may pop speculative bubbles driven by historically low interest rates.
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. Tapering is withdrawing from a monetary stimulus program that has been executed and quantitative easing policies have stabilized the economy. Tapering may include changing the discount rate or reserve requirements and the Federal Reserve will also reduce its asset holdings. Normally, when a central bank wants to reduce the cost of borrowing for companies and consumers, it lowers its target short-term interest rate. But with its target rate at zero during the 2008 crisis – at the same time that there was no inflation and the economy was still hurting – the Fed was no longer able to cut rates further.
What Is the Difference Between Tapering and Tightening?
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 the Fed’s bond portfolio by mid-2022. Growing concerns among economists that rising inflation could harm the economy are likely a big part of what led the Fed to begin tapering. Tapering does not involve selling the securities that the central bank purchased; it’s merely winding down the pace at which those securities are bought. The Fed started tapering its purchases in December 2021 and by the spring of 2021, the economy showed significant strength and a cost-of-living surge.
The Fed is hoping to find a balance between supporting a still-vulnerable economy while containing the inflationary pressures sparked by the pandemic’s ebb. Among its peers, the European Central Bank and the Bank of Japan appeared furthest from tapering their own bond programs, while other central banks, particularly in Latin America, rushed to raise interest rates in an effort to cool price increases. 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 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.