An Explanation of Fed Tapering and Its Impact on the Markets
Tapering, in the financial world, refers to the winding down of certain activities by a central bank. One program that saw tapering in 2013 and 2014 is quantitative easing—the Federal Reserve's purchase of assets, including mortgage-backed securities and other assets with long-term maturities, to help bring down interest rates.
Quantitative easing was put in place in response to the 2007-2008 financial crisis. The Fed hoped the program would help banks feel comfortable lending money again. The program was meant to temporarily stimulate the economy, and after the Fed saw a favorable impact on inflation and employment, it announced that it would taper its buying program. In other words, it would purchase fewer assets each month.
Origin of the Tapering Discussion
The “tapering” terminology entered the financial lexicon on May 22, 2013, when U.S. Federal Reserve Chairman Ben Bernanke stated in testimony before Congress that the Fed may taper, or reduce, the size of its bond-buying program known as quantitative easing (QE).
This was just one of many statements made by Bernanke that day. However, it was the one that received the most attention, because investors were already concerned about the potential market impact of a reduction in a policy that had been so favorable for both stocks and bonds.
Bernanke followed up on those statements in a news conference after the Fed's July 19, 2013 meeting. While stating that the quantitative easing policy remained in place, the Fed chairman also said that the policy was dependent on incoming data. Given the improvement in the U.S. economy, he expected this data-driven approach would prompt him to begin to taper QE before the end of 2013, with the program ending entirely in 2014.
With this as background, the markets expected the tapering to occur at the Fed's Sept. 18, 2013, meeting. However, the central bank surprised the markets by electing to keep QE at $85 billion per month.
This shift was likely caused by two factors: a string of weaker economic data that had been released in the prior month, and the prospect of slower growth stemming from the oncoming government shutdown and debt ceiling debate. As a result, the Fed opted to delay the start of tapering.
By December, the economy had become strong enough for the Fed to feel confident in reducing the level of stimulus. In its December meeting, the Fed reduced QE by $10 billion, down to $75 billion per month. The tapering continued on January 29, 2014, with the Fed announcing that the continued improvement in economic conditions warranted a further reduction in QE, and the central bank remained on track to have the program wound down before year-end. The Fed opted for this gradual approach to create minimal market disruption.
Market Reaction to Tapering
While Bernanke’s tapering statement in May 2013 didn’t represent an immediate shift, it nonetheless frightened the markets. In the recovery that followed the 2008 financial crisis, stocks and bonds both produced outstanding returns despite economic growth that was well below historical norms. The consensus was that Fed policy was the reason for this disconnect.
Late in 2013, a widely held belief was that once the Fed began to pull back on its stimulus, the markets would start to perform more in line with economic fundamentals. In this case, that meant weaker performance. Bonds indeed sold off sharply in the wake of Bernanke's first mention of tapering, while stocks began to exhibit higher volatility than they had previously. However, the markets subsequently stabilized through the second half of 2013, as investors gradually grew more comfortable with the idea of a reduction in QE.
With the economic recovery gaining traction through 2014, and with investors maintaining a healthy appetite for risk, the process of tapering resulted in stocks and bonds that performed very well. This outcome indicated that the Fed was correct in its decision to taper its quantitative easing policy—as well as in its timing and approach to the policy.
The End of Quantitative Easing
After a series of reductions throughout 2014, the tapering concluded, and the program ended following the Fed's Oct. 29–30, 2014 meeting. The end of QE was a positive sign for the United States, as it indicated that the Fed had enough confidence in the economic recovery to withdraw the support provided by QE.
2017 Introduces "Quantitative Tightening"
In October 2017, the Fed took the extra step of quantitative tightening. The Fed was no longer adding assets to its balance sheet every month, and it then decided to reduce the assets it held every month. In other words, the Fed had tapered back to $0 in additional assets every month, and it was now tapering into negative territory.
These balance sheet reductions continued until August 2019. At that point, the Fed's balance sheet held less than $3.8 trillion in assets. That's down from its high of more than $4.5 trillion in 2015. The figure hovered around $4.5 trillion until quantitative tightening began in 2017.
Beginning in September 2019, the Fed reversed course again and began adding assets to its balance sheet. As of Nov. 18, 2019, the Fed's balance sheet held more than $4 trillion in assets.
Effects of the Fed's Shrinking Balance Sheet
The market reacted less dramatically to quantitative tightening than it did to quantitative easing. Still, the reduction of the Fed's balance sheet holdings has certain effects on the economy. Balance-sheet shrinking is essentially dumping billions of dollars' worth of bond holdings back into the market, which could raise long-term Treasury interest rates. Other potential effects include:
- Quantitative tightening could have contributed to rising mortgage rates in 2018, as investors bought fewer bonds and started to worry more about inflation.
- Mixed feelings about quantitative tightening among investors could have added to stock market turbulence in 2018 (though many factors contributed to the turbulence).