What Is Tapering and How Does It Affect Stock Prices?

What is tapering? Why do stock investors expect prices to fall once tapering begins? In this post, we'll look at what tapering means and how it affects the market as a whole.

Tapering: Key Takeaways

Central banks adjust monetary policy from time to time to match market conditions and government policy. Right now, quantitative easing, which means printing dollars, may seem like a given, but no monetary policy lasts forever.

Tapering is the policy of scaling back quantitative easing. In other words, tapering is also an economic policy in its own right. Tapering aims to control interest rates and to manage how investors perceive the existing quantitative easing. It's also a signal that the dollar may strengthen as monetary policy changes, so it may be wise to prepare for falling asset prices. Tapering is usually carried out after quantitative easing has achieved its goals of stimulating and stabilizing the economy.

• Tapering is the opposite of the quantitative easing that central banks carry out to grow the economy.
• Specifically, tapering means a reduction in a central bank's purchases and accumulation of assets.
• Because markets have come to rely on financial stimulus through quantitative easing, tapering can send them into a downturn. This is called a taper tantrum.
• A taper tantrum can actually prompt the central bank to step up its asset purchases again, because the economy may contract.

Tapering and the Role of Central Banks

Central banks roll out stimulus measures and often promise to reverse them once the economy recovers. This is because simple stimulus that just pumps money into the economy can lead to runaway inflation, asset bubbles, and an overheated economy.

Tapering is when a central bank that has been following a quantitative easing policy slows down its new asset purchases. If the central bank slows its asset purchases, asset prices may fall and interest rates may rise, right? Tapering is the first step in scaling back, or fully withdrawing, the monetary stimulus that has been in place.

How Do Central Banks Carry Out Tapering?

Central banks generally prefer to change expansionary monetary policy gradually rather than stop it abruptly. This lets investors and markets prepare for upcoming policy changes and reduces market uncertainty. By giving the market time to adjust on its own before quantitative easing is actually withdrawn, central banks aim to minimize disruption to the economy and the markets.

Is Tapering Just a Theory?

The U.S. Federal Reserve (Fed) and other central banks have announced plans to scale back quantitative easing over recent decades. So far, however, central banks have proven unable or unwilling to carry out sustained tapering, let alone fully unwind quantitative easing.

Central banks around the world, including the U.S. Federal Reserve, the Bank of England, the European Central Bank, the Swiss National Bank, and the Bank of Japan, have tried to scale back quantitative easing, but in the end they only ended up setting new records for asset purchases.

Sweden's central bank successfully tapered from 2010 to 2011, but it has carried out quantitative easing steadily ever since. For this reason, many believe that central banks actually scaling back quantitative easing and tapering is nothing more than a theory.

One reason may be a phenomenon called the taper tantrum: investors can react drastically when a central bank slows its stimulus.

For example, a central bank's tapering announcement is usually accompanied by a sharp rise in government bond yields and a drop in the stock market. Central banks can't help but pay attention to this, because they don't want to cause financial losses for their country's businesses and citizens.

The Effects of Tapering

At its core, quantitative easing is a monetary policy the U.S. Federal Reserve uses to grow the economy. U.S. quantitative easing programs have included purchases of mortgage-backed securities and other long-term investment assets. These purchases reduced the supply of bonds on the open market, which led to higher asset prices and lower long-term interest rates.

Lower interest rates, in turn, lead to lower borrowing costs. In theory, lower borrowing costs allow businesses to pursue new projects, which creates jobs. Job creation boosts consumer spending and drives economic growth.

When tapering, the opposite of quantitative easing, is carried out, it can lead to falling asset prices and rising long-term interest rates. This raises borrowing costs and may lead to a slowdown in business activity and higher unemployment. As a result, overall consumer sentiment may weaken and the economy may decline.

How Tapering Affects Stock Prices

The quantitative easing carried out after the 2007-2008 financial crisis drove up stock and bond prices in U.S. financial markets. As a result, investors often worry that tapering will cause prices to fall.

In practice, however, tapering is a theoretical concept that, unlike quantitative easing, has never been successfully carried out by a central bank. So it's hard to say for sure how tapering would affect the stock market.

Many believe the stock market will react negatively to tapering, as central banks scale back economic stimulus, but we'll have to wait and see what actually happens.