What is Tapering?
Tapering is the incremental reversal of a central bank's quantitative easing strategy designed to boost economic growth. As with most, if not all, economic stimulus measures, they're supposed to be unwound until policymakers are assured that the desired outcome has been achieved, usually self-sustaining economic growth.
Understanding Tapering
Tapering can only come true if some kind of stimulus program has already been operated. The latest example was the US-implemented quantitative easing (QE) programme. Federal Reserve System (FRS), known as the Fed in colloquial terms, in response to the financial crisis of 2007-08.
Tapering efforts are aimed primarily at interest rates and at controlling investor perceptions of what those rates will be in the future. These may involve modifications to traditional central bank activities, such as changing the discount rate or reserve requirements or more unorthodox ones, such as quantitative easing (QE).
QE broadens the Fed's balance sheet by purchasing long-maturity bonds and other financial assets. These purchases drive down the supply available, which leads to higher prices and lower yields (long-term interest rates).
Lower yields lower the borrowing costs, which should make it easier for companies to fund new projects that generate jobs leading to higher demand and economic growth. Basically, it's a fiscal policy tool in the Fed's toolbox to stimulate the economy that will be gradually rescinded or tapered once the goal is met.
Philosophy Behind Tapering
Central banks may follow a range of growth-enhancing strategies and must match short-term economic changes with longer-term market expectations. If the central bank tapers its operations too fast, it could push the economy into recession. If it does not taper its operations, then an unwanted increase in inflation could be an offing.
It helps to set market expectations by being open with investors regarding future banking activities. That's why central banks typically use a gradual taper to loose monetary policies, instead of an abrupt stop. Central banks minimize market volatility by outlining their tapering strategy and defining the conditions under which the tapering will either start or end. In this respect, any anticipated reductions are spoken of in advance, allowing the market to start making adjustments before the activity actually takes place.
