Fed tapering: How the US central bank gradually dials back its bond-buying stimulus

• Tapering is how the Federal Reserve throttles back economic stimulus by slowing the pace of its asset purchases.
• The Fed began to taper its current bond-buying program in November 2021.
• Tapering is a controlled way to phase out quantitative easing while managing the continued economic recovery.
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In times of economic distress, the Federal Reserve may resort to a process known as quantitative easing (QE), in which it buys massive quantities of government bonds and mortgage-backed securities to increase the money supply, encourage lending, and lower interest rates in order to stimulate a lagging economy. Once the goals of that stimulus are met, the Fed may gradually begin to unwind the purchases and raise interest rates to allow the economy to restabilize. This process is known as tapering.

"Tapering is like slowly taking your foot off the accelerator," says Gary Zimmerman, founder and CEO at MaxMyInterest. "Your speed starts to decrease but you're still adding gas to the engine and moving forward."

What does the Fed mean when it talks about tapering?

In March 2020, when the COVID-19 pandemic brought parts of the economy to a virtual standstill, the Fed initiated both of the means at its disposal to stimulate growth — cutting interest rates and purchasing assets. After reducing short-term interest rates to zero, the central bank began buying bonds and mortgage-backed securities at a rate of $120 billion per month. At the time, Fed officials said the process would continue until "substantial further progress has been made toward our maximum-employment and price-stability goals."

After nearly a year of widespread public speculation, the Fed decided the goals had been met and in November 2021 said that it was time to taper. This was the point at which the Fed figuratively began to lift its foot from the accelerator by reducing the monthly pace of Treasury purchases by $10 billion and of mortgage-backed securities purchases by $5 billion. At the same time, policy makers signaled that they would not tap the brakes and raise interest rates until tapering is finished in mid-2022.

Why does the Fed buy assets?

Prior to the 2008 global financial crisis, the primary method the Fed used to fight a recession was to lower interest rates, which stimulated economic activity and allowed banks to lend to more people. Given the magnitude of the 2008 crisis, the Fed realized cutting short-term rates, even to zero, was not enough. That's when it began buying long-term bonds under quantitative easing, increasing the balances in Federal Reserve banks.

The increased demand from the Fed boosts the price of bonds, which lowers the yield . As a result, three things theoretically happen:

1. Banks have more money to lend at lower rates of interest.
2. Investments in lower-yielding bonds give way to investments in higher-performing stocks.
3. The economy goes into recovery mode.

   Note: A bond's yield falls as its price rises because the fixed coupon payment is diluted by the increased cost of the asset.

Why would the Fed taper its asset purchases?

The Fed's motivation for tapering is to slow down the economic stimulus it started to boost a sagging economy once the goals of the stimulus program have been met. The Fed declared those goals, "maximum employment" and "price stability," met in November, 2021.

Ultimately, quantitative easing cannot continue forever since it can lead to high inflation, have a negative impact on savings and pensions, and devalue the dollar. Tapering is a controlled way to slowly end QE while managing the continued economic recovery.

Note: Tapering refers to a reduction in the amount of securities that the Fed is purchasing on a regular basis. It does not involve selling the securities.

What happens when the Fed tapers?

Tapering, like quantitative easing, involves manipulation of the economy. Investors can interpret a sped-up taper as a sign interest rates will be raised soon, resulting in a panic as was seen when Fed officials indicated that they would begin tapering the asset-purchase program put in place amid the global financial crisis. On the other hand, tapering too slowly, or failing to raise interest rates at the right time, can fuel inflation.

"Historically, when the Fed tapers and hikes interest rates, you usually see bond prices go down and interest rates move up, and actually you see the stock market do well over the following 12 months because when the Fed is tightening it's due to a strengthening economy," says Heeten Doshi of Doshi Capital Management. "This time around, despite the Fed accelerating its taper, we've actually seen interest rates rally because the bond market is worried about COVID."

Zimmerman points out the impact of tapering on two different slices of the income strata.

"Those who rent rather than own their home and who may have few, if any, long-term investments will see inflation erode their purchasing power faster than their incomes will rise," Zimmerman says. "By contrast, those who own homes will likely see the nominal value of their home increase at the pace of inflation. And people who hold investments like stocks benefit from a low interest-rate environment, which makes future cash flows worth even more in today's dollars, pushing company valuations up."

What happened the last time the Fed tapered?

In May 2013 when then-Fed Chairman Ben Bernanke suggested that the central bank was considering scaling back asset purchases, US Treasury yields surged as financial markets panicked in what was referred to as a "taper tantrum."

The taper, once it actually began, "was a unique situation for the market," Doshi says. "The Fed was in uncharted territory and had never put so much liquidity into the system and so the market was worried about what would happen when the Fed began to taper and tilt more hawkishly. In the end, the taper tantrum was unjustified, the economy continued to grow, and the stock market continued to move higher. I don't think you'll see a repeat of that this time around. I think investors learned their lesson."

The financial takeaway

Tapering, as counterpoint to QE, provides necessary balance to the effects of lowered interest rates and huge infusions of cash into the economy. It's a way for the Fed to pull back and allow an injured economy to continue to heal and grow, using the Fed's primary tests — maximum employment and price stability.

It's important to understand that tapering, like QE, is a fairly recent addition to the Fed toolkit. Furthermore, each situation that requires both QE and tapering is different from the one that came before. There is, as yet, no best way to respond to the effects of tapering, other than to realize that, at its essence, tapering is an attempt to return to "normal." Until then it's best to pay attention but not panic.

Via PakApNews