Fed Tapering and Its Impact on the Markets

Central banks, such as the U.S.Federal Reserve (Fed), can stimulate economic recovery by buying asset-backed securities. This process, along with maintaining a low interest rate, is called “quantitative easing (QE).” But central banks can’t endlessly purchase securities and pump money into the economy. When they believe the economy has recovered sufficiently, they work on winding down asset purchases or “tapering.” 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.

  1. When they believe the economy has recovered sufficiently, they work on winding down asset purchases or “tapering.”
  2. “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.
  3. “It would be premature to raise rates now,” he said in response to a subsequent question about inflation.
  4. That may have a significant impact on interest rates—and thus also on the economy and the markets.
  5. Tapering refers to the Federal Reserve practice of reducing the pace of its purchases of securities.

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. Tapering is initiated after the quantitative easing policies have stabilized an economy and may include changing the discount rate or reserve requirements. In the United States, the Federal Reserve will also reduce its asset holdings.

The Fed also put in place a plan to reduce its balance sheet of nearly $9 trillion in asset holdings it accumulated in recent years, mostly Treasury and mortgage-backed securities the beginning of the Fed’s money-tightening measures. Hulbert notes that the Fed traditionally seeks to raise interest rates amid a booming economy to keep it from overheating. In either case, the upshot of his analysis is that economic fundamentals other than interest rates tend to have a bigger impact on stock prices. Indeed, as noted above, the Fed has been sending out signals about tapering for much of 2021.

Tapering, explained: Federal Reserve to reel back massive bond-buying program

When the government buys assets, their prices go up, which lowers their yield or interest rate. Fed tapering introduces uncertainty to the market, a departure from the Fed’s steady asset purchases. That uncertainty could be viewed negatively and thus cause put downward pressure on stock prices. However, the Fed would only be expected to taper in response to strong economic conditions, and that means any downward pressure on stock prices would be met with an overall bullish economic environment.

Continuing to stimulate an economy with easy money once a recession has eased can lead to inflation and monetary policy-driven asset price bubbles. 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. And so the Fed turned to quantitative easing as a way to continue to reduce borrowing costs.

Buying securities in this fashion injects more newly printed money into the system and is known as monetary stimulus. 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 https://www.forex-world.net/blog/theory-of-reflexivity-george-soros-theory-of/ Reserve will also reduce its asset holdings. The Fed implements quantitative easing as one of its tools to stimulate the economy. Like all economic stimulus programs, QE policies are not intended to be permanent and after the desired results of an economic stimulus program have been achieved, those policies must be gradually rescinded.

In October 2017, the Fed began reducing the size of its inventory by allowing securities it was holding to mature without replacing them. This has the opposite effect of buying assets, causing the money supply to shrink. In March 2020, the Fed restarted quantitative easing in response to the COVID pandemic. 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. 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.

How Tapering Works

Tapering is often seen at changes in the business cycle, as the economy switches from slow growth to faster expansion. The Fed has made clear that tapering will precede any increase in its target for short-term interest rates. So tapering not only reduces the amount of QE, it is also seen as a forewarning of tighter monetary policy to come, as was observed why you can’t invest in bitcoin in the aftermath of the Great Recession. The combination of projected reductions in asset purchases and the possibility of higher rates in 2013 led to a period of high volatility and rising rates in the bond market—an episode that became known as the taper tantrum. To understand how tapering works requires a deeper understanding of quantitative easing.

However, the extent of that impact can vary depending on whether the markets are expecting the taper or if it comes as a surprise. In addition to doubling the pace of its tapering, the Fed also signaled that it could hike interest rates up to three times in 2022. 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.

What is the Fed taper? An economist explains how the Federal Reserve withdraws stimulus from the economy

That may have a significant impact on interest rates—and thus also on the economy and the markets. 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.

On Wednesday, Federal Reserve Chair Jerome Powell said during his post Fed-meeting news conference, “We’re basically two meetings away now from from finishing the taper.” Consumers and companies are already beginning to see slightly higher rates on mortgages, business loans and other types of borrowing. The Fed’s balance sheet ballooned from $4.3 trillion in March 2020 to over $8.9 trillion by May 2022. SmartAsset Advisors, LLC (“SmartAsset”), a wholly owned subsidiary of Financial Insight Technology, is registered with the U.S. Erika Rasure is globally-recognized as a leading consumer economics subject matter expert, researcher, and educator.

She is a financial therapist and transformational coach, with https://www.topforexnews.org/books/one-up-on-wall-street-pdf-download-full/ a special interest in helping women learn how to invest.

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