What’s a Taper, and Why Has the Fed Started Tapering?

(Bloomberg) -- The financial world spent much of 2021 arguing over when “the taper” would begin. In the U.S. it arrived, and there’s no end of questions about its impact. Tapering is shorthand for a gradual end to the massive bond-buying program the Federal Reserve unleashed in early 2020, when the pandemic crashed the economy. The Fed is hoping to find a balance between supporting a still-vulnerable economy while containing the inflationary pressures sparked by the pandemic’s ebb. Among its peers, the European Central Bank and the Bank of Japan appeared furthest from tapering their own bond programs, while other central banks, particularly in Latin America, rushed to raise interest rates in an effort to cool price increases. 

1. Why taper?

The hope is that by gradually trimming its purchases of Treasuries and government-guaranteed mortgage-backed securities, the Fed will help wean the economy slowly off the extra stimulus the purchases provide to avoid a crash landing. The Fed had been buying $120 billion of bonds per month. It began trimming that by $15 billion a month starting in November, a pace that would bring the program to an end in mid-2022. In December, reacting to surging inflation, the Fed decided to double the pace of tapering, which would bring the bond buying to an end in March.

2. How much did the Fed buy?

From early March 2020 to late November 2021, the Fed more than doubled the value of its assets, to $8.7 trillion. An initial lump of purchases came in a three-month scramble described as a way of maintaining market liquidity; the bank switched to steady monthly purchases in December 2020, saying that pace would continue until there was “substantial further progress” in the economic recovery.

3. What’s the idea?

The Fed’s usual method of fighting recessions is to push down interest rates, stimulating economic activity by allowing banks to offer cheaper loans. But in the wake of the 2008 financial crisis, the Fed realized that cutting the short-term rate it controls virtually to zero was not medicine enough. So it began buying long-term bonds, whose rates are set by the market, a program called quantitative easing. Adding to the demand for long-term bonds lowered their yields.

4. Do other central banks use this tool?

Yes, including the Bank of England, the BOJ and the ECB. The latter two never stopped the bond purchases they started after the financial crisis and stepped up their buying after the pandemic hit. The Covid-19 crisis also led a number of banks that had not previously bought bonds to join in, including the central banks of Canada, Chile and Indonesia.

5. Has the Fed tapered before?

Yes, and it went pretty smoothly after an initial glitch. When then-Fed Chairman Ben Bernanke suggested in May 2013 that the central bank was just considering scaling back its bond purchases, financial markets took fright in what was dubbed the “taper tantrum.” The subsequent rise in long-term interest rates hit the U.S. housing industry and emerging markets hard. The Fed announced the actual taper in December 2013; starting the next month, purchases were cut by increments of $10 billion per month until they ended in October 2014.

6. Why is the Fed tapering now?

As the U.S. economy rebounded strongly from the pandemic, supply chain bottlenecks and pent-up demand drove inflation to its highest since 1982. Meanwhile, the labor market continued to add jobs, with unemployment falling to 4.2% in November. Even as the taper began, Fed Chair Jerome Powell suggested its pace might be quickened in response to price pressures. He and other Fed officials stressed that interest-rate increases would not be considered until the taper was done. Fed policy makers in December projected three interest-rate hikes in 2022, the most hawkish pivot in more than a decade.

7. What’s at stake? 

A lot. The gusher of cash the Fed poured into the financial system helped drive U.S. stocks and housing prices to record highs. Investors could interpret a sped-up taper as a sign that the Fed will move rate hikes forward. Tightening policy too quickly could derail the economic recovery at a time of continued uncertainty over the duration of the health crisis. Moving too slowly could fuel inflationary pressures. That prospect became more worrisome when energy prices began rising as winter fuel shortages loomed in Europe and Asia.

8. Are other central banks following suit? 

The ECB said it would cut the level of its bond-buying in the final quarter of 2021. But its president, Christine Lagarde, insisted the move wasn’t a taper, just an adjustment of a program still set to continue. BOE officials laid the groundwork for tighter monetary policy there, while central banks in Brazil, Chile, Mexico and Paraguay, along with those in Hungary, New Zealand, Norway and Pakistan, have responded to inflation by increasing borrowing costs. Still, JPMorgan Chase & Co. economists estimate developed market central banks will add a net $1.5 trillion in assets to their balance sheets in 2022.

The Reference Shelf 

• The Fed’s Nov. 3 statement on the taper.
• More QuickTakes on the Fed’s original taper, how the Bank of Japan handled taper speculation, how central banks responded to Covid-19, negative-yielding bonds, and what quantitative tightening is.
• Bloomberg Opinion’s Marcus Ashworth on why the Fed is watching the BOE, Daniel Moss assesses Australia’s stance, and Mark Gilbert argues the ECB should stand pat.
• The Brookings Institution goes deeper into the Fed and tapering.

©2021 Bloomberg L.P.