An Explanation of Fed Tapering and Its Impact on the Markets
Tapering refers to the winding down of certain activities by the Central Bank. The Federal Reserve implemented a program to buy assets such as those with long-term maturities, including mortgage-backed securities, to help bring down interest rates.
This program, called quantitative easing, was put in place in response to the 2007 financial crisis to get banks comfortable with lending money again. The Fed announced that once it saw a favorable impact on inflation and employment, it would taper its buying program, reducing its purchases each month.
Fed Tapering in Depth
The “tapering” terminology entered into the financial lexicon on May 22, when U.S. Federal Reserve Chairman Ben Bernanke stated in testimony before Congress that that Fed may taper, or reduce, the size of its bond-buying program known as quantitative easing (QE). The program, implemented to stimulate the economy, has served the secondary purpose of supporting financial market performance in recent years.
While Bernanke's surprising pronouncement led to substantial turmoil in the financial markets during the second quarter, the Fed did not officially announce its first reduction in QE until December 18, 2013, at which point it reduced the program to $75 billion per month from its original level of $85 billion.
The reason for this move was that the economy had become strong enough for the Fed to feel confident in reducing the level of stimulus. The tapering continued on January 29, with the Fed announcing that the continued improvement in economic conditions warranted a reduction in QE, and the central bank remained on track to have the program wound up before year-end. The Fed opted for this gradual approach to create minimal market disruption.
Market Reaction to Tapering
While Bernanke’s tapering statement didn’t represent an immediate shift, it nonetheless frightened the markets. In the recovery that has followed the 2008 financial crisis, stocks and bonds both produced outstanding returns despite economic growth that was well below historical norms. The general consensus, which is likely accurate, is 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, which, in this case, 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 investors maintaining a healthy appetite for risk, the process of tapering had no real market impact. In fact, stocks and bonds performed very well, indicating that the Fed was correct in its decision to taper its quantitative easing policy, as well as in its timing and approach.
Ending Quantitative Easing
The U.S. Federal Reserve finished tapering its stimulative quantitative easing policy in 2014. On December 18, 2013, the Fed began to taper its bond purchases by $10 billion per month, to $75 billion. After a series of reductions throughout 2014, the tapering concluded, and the program ended following the Fed's October 29–30 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.
Current Status: Quantitative Tightening
A study assembled by a group of top economists, released in February 2018, concluded that the Fed's balance sheet size has less power over the bond market's movements than many had previously believed.
The Fed made a decision in Fall 2017 to start shrinking its balance sheet, which had grown due to the buying activity from its quantitative easing program. Instead, quantitative tightening has begun with the Fed reducing its balance sheet assets by $20 billion each month during Q1 of 2018. The reductions will escalate throughout 2018, with reductions of $50 billion per month by year-end.
To date, the study noted that the Fed's announcement of its balance sheet reductions has caused little more than a "collective shrug" in the market. This reaction is in contrast to what was termed the "taper tantrum" in 2013 as the market had a substantial reaction when the Fed announced it was tapering off its bond-buying activity, and consequently, its efforts to boost the economy.
Origin of the "Tapering" Discussion
The issue of tapering first moved into the public consciousness when Bernanke, asked about the timing of a potential end to the Fed’s quantitative easing policy in his May 22 testimony, stated, “If we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings ... take a step down in our pace of purchases.” This was just one of many statements made by Bernanke that day. However, it was the one that received the most attention because it came at a time that investors were already concerned about the potential market impact of a reduction in a policy that has been so favorable for both stocks and bonds.
For a full, up-to-date explanation of Fed policy, see Current Federal Reserve Policy: A Layperson’s Explanation.
Bernanke followed up his previous statements in the press conference that followed the Fed's meeting on July 19. While stating that the quantitative easing policy remained in place for the time being, 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 September 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 until its December 2013 meeting.
The potential for tapering existed from the beginning of the QE program. Quantitative easing was never intended to last forever, since each bond purchase expands the Fed’s balance sheet by increasing the number of bonds it owns.