Tapering is a term used in economics that refers to the gradual reduction of the monetary policy stimulus that a central bank has put in place to promote economic growth. In the case of the United States, the Federal Reserve (Fed) has implemented a quantitative easing program, which involves buying government bonds to increase liquidity and lower interest rates.
Why Tapering is Needed
The Fed’s approach to coping with the economic impact of the Covid-19 pandemic has been to reduce interest rates to near-all-time lows and to “print” money through quantitative easing. By cutting interest rates to 0-.25%, the Fed is hoping to incentivize banks to lend money to each other at a lower cost, making borrowing easier. The Fed’s plan is that banks will turn around and lend that super cheap money to the average Joe, who could use the funds to start or expand a business. Banks, on the other hand, can make a profit by loaning the money to average Joes at 5-10% interest.
However, reducing interest rates alone doesn’t alleviate the risk of banks’ overall portfolios as most still hold high-risk assets — which is what the average Joe loan would be considered in the eyes of the banks. With that said, even while interest rates are at all-time lows and banks are still holding onto their money, the Fed then has to use another tool to try to spur economic growth, namely, quantitative easing. QE impacts the quantity or amount of money in the market. The government “prints” a bunch of money to create inflation while buying the risky defaulting assets of the bank as well as buying “their own” 10-year treasuries (something I like to call, going to the casino).
By buying bankers’ bad debt, the banks are more inclined to take a risk on the average Joe because their riskier assets have been taken off their balance sheet by the Fed purchasing them. By purchasing 10-year treasuries, it creates more demand for the 10-year treasuries, which lowers the yield. Banks that were buying 10-year treasuries which were returning 2% are now returning 1-ish% and they aren’t as attractive. With less risk on their balance sheets and no great risk-free return (interest rates and treasuries), they have no place else to go than to the stock market, average Joe loans, or alternative investments.
When Tapering Happens
The need for the Fed to taper its quantitative easing program arises when the economy has recovered sufficiently to warrant withdrawing the stimulus. This is because the program was implemented in the first place to provide support during times of economic turmoil. As the economy recovers, the need for such support lessens, and it becomes appropriate to gradually reduce the amount of stimulus provided.
To signal its intention to taper, the Fed announces that it will gradually reduce the number of bonds it buys each month. However, the timing of the tapering depends on market conditions. If the economy is in a strong position, with low unemployment rates and rising inflation, the Fed is more likely to start tapering. Additionally, if there are signs that the economy is overheating, such as rapid growth in GDP, the Fed may also choose to taper.
It is important to note that the Fed must carefully consider the impact of tapering on the economy. A sudden or hasty reduction in stimulus could have negative consequences, such as slowing down economic growth or causing a market downturn. Therefore, the Fed must take into account a variety of factors, such as market conditions, the state of the economy, and the potential impact of tapering on various sectors before deciding to take action.
Impact of Tapering
The Fed’s tapering plans are closely watched by investors, as they can have a significant impact on the financial markets. If the Fed tapers too quickly, it could cause a sudden rise in interest rates, which would be bad news for investors in bonds or other fixed-income assets. On the other hand, if the Fed continues its quantitative easing program for too long, it could lead to inflation, which would be bad for the economy as a whole.
To sum up, tapering refers to the gradual reduction of a central bank’s monetary policy stimulus, and it is a signal that the economy is recovering. In other words, tapering is when they stop buying banks’ risky and bad investments and stop printing money intentionally lowering yields on traditionally safe investments (interest rates and treasury bonds).
The Fed’s quantitative easing program has been a key tool in promoting economic growth during the Covid-19 pandemic, but the time has come for the Fed to start tapering its bond purchases. The Fed must strike a balance between withdrawing the stimulus too quickly and keeping it in place for too long, and the stakes are high for the economy and financial markets.
Hopefully, this gives you a better idea as to the connection between rising yields and the scare it places on institutional investors (because the bull run on the stock market will slow or reverse considering banks will start finding those yields attractive enough to invest again — and if this happens too fast, it can cause panic to those unaware of what is happening). This is why tapering is such an important or even taboo topic in the financial community.