Key Takeaways
- Gradual reduction of Fed asset purchases after QE.
- Signals economic improvement and prevents inflation overheating.
- Raises bond yields, increasing borrowing costs and market volatility.
What is Tapering?
Tapering is the gradual reduction by the Federal Reserve in the pace of its asset purchases, such as U.S. Treasury securities and agency mortgage-backed securities (MBS), following periods of quantitative easing (QE). This approach carefully removes monetary stimulus to avoid market disruption while signaling economic recovery.
By scaling back purchases incrementally, tapering prepares markets for eventual interest rate hikes and a return to more conventional monetary policy.
Key Characteristics
Tapering involves specific features that balance stimulus withdrawal and market stability:
- Gradual Reduction: The Fed decreases asset purchases in fixed increments to prevent shocks.
- Market Communication: Announcements are strategically timed to manage investor expectations, often highlighted at events like the Jackson Hole Symposium.
- Economic Triggers: Decisions rely on data such as labor market strength and inflation trends.
- Impact on Yields: Reduced bond demand typically causes rises in yields, influencing borrowing costs and the yield curve.
- Precursor to Rate Changes: Tapering usually precedes tightening monetary policy to keep inflation near the Fed’s 2% target.
How It Works
The Federal Open Market Committee (FOMC) announces tapering by specifying the monthly reduction in asset purchases, often in $10 to $15 billion steps. For example, after the 2008 crisis, the Fed cut its monthly purchases from $85 billion to $75 billion, aiming to end QE by mid-2014.
During tapering, the Fed continues reinvesting maturing securities to stabilize its balance sheet before eventually allowing it to shrink. This process affects labor market conditions and overall macroeconomics by signaling policy normalization and influencing interest rates across the economy.
Examples and Use Cases
Tapering has played a key role in shaping financial markets during recovery phases:
- Post-2008 Financial Crisis: The Fed’s gradual tapering announcement in 2013 caused the “Taper Tantrum,” which led to volatile bond markets and higher yields.
- COVID-19 Recovery: Starting in late 2021, the Fed reduced $120 billion monthly purchases by $15 billion increments, affecting mortgage rates and equity market rallies.
- Corporate Impact: Companies like Delta experienced changing borrowing costs and capital access during tapering phases, influencing their financial strategies.
Important Considerations
When anticipating tapering, investors should monitor economic indicators closely, especially inflation and employment data, to gauge the Fed’s timing and pace. Rapid or unexpected tapering announcements can increase market volatility.
In addition, tapering’s influence on bond yields affects sectors like housing and financials, making diversification across assets such as those covered in best large-cap stocks and best bank stocks important for managing risk.
Final Words
Tapering marks a shift toward tightening monetary policy as the economy strengthens, signaling reduced Fed support for asset markets. Monitor economic indicators like inflation and employment to anticipate its pace and impact on interest rates.
Frequently Asked Questions
Tapering is the Federal Reserve's gradual reduction in the pace of its large-scale asset purchases, like U.S. Treasury securities and mortgage-backed securities, after periods of quantitative easing to support the economy during crises.
The Fed tapers to signal that the economy has made substantial progress toward maximum employment and stable inflation, allowing it to withdraw stimulus carefully to prevent overheating or persistent inflation.
The Fed announces tapering through the FOMC, reducing monthly asset purchases in fixed increments, such as $10 billion or $15 billion per month, until purchases stop, often reinvesting maturing securities before allowing balance sheet runoff.
Tapering usually begins after economic recovery signs like strong jobs reports and inflation above 2%, often following crises, with the Fed carefully communicating plans to avoid market surprises.
Tapering tends to push bond yields higher, can cause stock sell-offs, increase borrowing costs like mortgage rates, and raise market volatility, but its gradual pace helps reduce shocks.
The 2013 'Taper Tantrum' occurred after the Fed's announcement to reduce asset purchases, causing bond yields to spike and stocks to drop sharply due to market fears of tightening monetary policy.
During the COVID-19 recovery, tapering started in late 2021 with clear Fed guidance, which helped stabilize markets despite rising mortgage rates and equity pressures, unlike the more volatile 2013 episode.
