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Federal Reserve's "Taper" Policy, Explained

Nov 9, 2021 7:35 AM 5 min read

Last week, the US Federal Reserve announced that it will begin slowing down its monthly asset purchases as the month progresses, starting with the speed of $15bn per month. 

As far as announcements go, this was far from unexpected. In fact, in a way, it was long overdue. After the global economy was ravaged by the pandemic last year, world governments scaled up liquidity injection into the markets through asset purchases, interest rate cuts and other measures to stabilise its impact. 

But now the process of recovery is picking up pace, so is the willingness and readiness of governments (and Central Banks) to return to status quo, that is, unwind the massive asset purchases. Not only is this aimed at normalising towards pre-pandemic economies but it is also intended to keep a lid on the spiralling inflation. 

Let's understand how this is done and what this policy shift in the US means for India. 

Tapering and Tightening

Tapering is more of a colloquial term rather than a technical one that traces its origins back to 2008. In essence, tapering is what follows after a period of aggressive economic stimulus. Usually, the stimulus is offered in the form of near-zero interest rates and massive investments in bonds. Collectively, these measures are called quantitative easing.  

As of now, the Fed is buying $80bn worth of Treasury securities and $40bn of mortgage-backed bonds every month (the largest asset purchase program in history). 

How does this help? It makes borrowing easier, keeps yields near rock-bottom and puts more money back into the economy that helps combat against the sudden impacts of an economic downturn (caused by, say, a pandemic).

However, Central Banks like the Fed can't go on buying securities endlessly and pumping money into the system. After a point, the stimuli work their trick and the economy is believed to have recovered sufficiently. That is when tapering begins.

FYI: Tapering does NOT mean selling the asset-backed securities that the Fed purchased earlier. It's merely winding down the pace at which those securities are bought. 

So, essentially, tapering is a sign that the Central Bank is tightening its monetary policy. It could also be a precursor to higher interest rates. Initially, it impacts the bond and the debt markets in the US by influencing the supply of these securities. But in time, it can also move the equity and other markets around the world.


Why Taper Now?

One, the phenomenal vaccine makeover. With many large nations approaching optimistic vaccination numbers, economies have reopened and pace of activities quickened. Between children's vaccines being rolled out in the US and promising results coming from Pfizer's antiviral COVID-19 drug (risk minimisation by 90%), markets have turned largely favourable signalling strong fundamentals. 

Two, the economy is bouncing back quite fast. It no longer needs the support of extreme policy measures to sustain. Rather, it could benefit from a bit of loosening up because some of the policies have done more harm than good. 

For instance, low interest rates have sparked a boom in the housing market. Excess liquidity has also meant overheating of the economy, i.e. Inflation, which has indirectly led to other afflictions like the supply chain crisis. Point is, the most direct objectives of the bond-buying exercise have been achieved already. 

Three, the ongoing stock market boom. By buying up debt, the Fed was essentially turning on a money spigot which, in turn, fuelled a bull run in the markets and a rebound from the crashes of March-April 2020. 

But as the dust settles, it remains important to gradually phase out of a liquidity spell. This is an ideal time to taper because slamming the brakes earlier or later than now could have triggered investor panic without the economy having gathered enough momentum to escape the rising inflation. 

That's what happened during the so-called Taper Tantrum of 2013 and it's a good idea for the Fed to prevent that from happening again.

Fourth, strong jobs reports. The labour market in the US has bounced back from its "summer lull" with the economy churning out more than half a million jobs in October. This has led to a sharp uptick in stock markets and decline in bond yields, setting the ideal stage for Jerome Powell & Co. To score towards the goal of maximum employment by taking out the training wheels in time i.e. Taper. 

Fifth, the Fed's ever-expanding ledger. The massive buying spree has led to a balance sheet sized at over $8trn likely to widen to $9trn. Agreed, THAT is the price of improving the financial health of the nation. But is it going to reduce any time soon? 

Experts think that's unlikely. The way forward, most believe, is to hold on to the balance sheet and let the economy grow into it so that eventually, the sheet would shrink as a percentage of the growing GDP

But normalising a figure that large will take time and orderly policy interventions, just like the bond-buying taper. 


Impacts Overboard

As mentioned earlier, tapering is a likely precursor to a hike in interest rate which has hovered around near-zero levels in the US since March 2020. That may happen once the FOMC (Federal Open Market Committee) is convinced that the economy and employment numbers are on a more solid footing. 

That could create a ripple effect across the world with Central Banks in other countries, including India, exiting from ultra-loose monetary policies. The first possible form of such exit could be reflected in RBI's changing stance from an accommodative (surplus liquidity) to neutral (liquidity in little deficit mode) policy.

The uncertainty still looms regarding how markets will react to the changed policy. Especially in emerging markets like India (The "Fragile Five") where following the last tapering in 2013, there was a rush of foreign portfolio (FPI) flows out of the country, decline in equity prices, decrease in foreign reserves and shooting up bond yields. 

But that was a decade ago. Today, the share of more stable FDIs in India have risen which makes the country less vulnerable to a turn in the US bond market and rate cycle. RBI has also managed to amass $600bn+ worth of forex assets that will come in handy in fighting against any potential speculative attack on the Rupee. 

India's FDI inflows also remain at record highs ($25bn in 2020) signalling a cementing in the country's status as an investment hotspot. However, that doesn't limit the possibility of a reversal in capital flow, especially during market sell-off episodes, potentially triggered by the Fed's taper exercise.

Like any large and liquid market, India too is vulnerable to taper events in the US. But the macroeconomic conditions and macro-prudential policies today indicate strong fundamentals unlike in 2013. In addition, the Fed's "taper talks" this time around have been gradual and imminent for months, slowly setting the stage to embrace any knee-jerk reactions that could worsen global economics. 


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