Tapering is the gradual reduction of a central bank’s large-scale asset purchase program, signaling a shift away from expansionary monetary policy.
Understanding tapering
During an economic downturn, a central bank may implement quantitative easing by purchasing government bonds and other securities. This action injects liquidity into the financial system and lowers borrowing costs. When the economy stabilizes and reaches targeted inflation or employment levels, the central bank reduces the pace of these purchases. This deceleration is tapering.
Tapering involves buying fewer assets each month than previously planned. It does not mean the central bank is selling its accumulated assets or immediately raising interest rates. The central bank’s balance sheet continues to expand during a taper, but the rate of expansion slows down over time until the net purchases eventually reach zero.
The prospect of tapering often causes volatility in global financial markets. Market participants may react to the anticipation of tighter monetary conditions and reduced liquidity. This reaction sometimes results in a market sell-off or a spike in government bond yields as investors adjust their portfolios ahead of the actual policy change.
Central banks around the world utilize tapering to manage their economies. Institutions like the European Central Bank, the Bank of Japan, and the Bank of England have all managed asset purchase programs and corresponding tapering cycles. Elephants monitoring global monetary policy pay close attention to central bank communications for hints regarding the timing and velocity of a taper.
Example
Imagine the Central Bank of the Savannah decides to stimulate the local economy by purchasing 100 tons of peanuts every month from agricultural suppliers. This adds cash to the system and keeps businesses funded. After two years, the economy recovers and inflation begins to rise. To cool the economy, the central bank announces a taper.
Instead of stopping abruptly, the central bank buys 80 tons of peanuts the next month, 60 tons the following month, and continues reducing the volume by 20 tons each month. The central bank is still buying peanuts, but the level of stimulus is decreasing. For Elephants trading Savannah currency and debt, this tapering schedule indicates that the period of maximum intervention is ending.