What is tapering?

    In finance, tapering refers specifically to the anticipated reduction of quantitative easing (QE) – the US Federal Reserve’s economic stimulus bond buying programme – with a view to potentially winding it down completely.

    Quantitative easing background

    The financial crisis of 2008 prompted the Fed to use stimulus measures to kick-start the US economy and keep interest rates low. The stimulus was never intended as a permanent solution.

    The term ‘tapering’ was first used in a financial sense in May 2013 by Federal Reserve Chairman Ben Bernanke, when he indicated in a statement that if the US economy recovered as expected, stimulus measures such as QE would start to be reduced.

    The financial press quickly started using the term too and the issue of when tapering would start, and to what extent, became a widely reported topic with a powerful impact on financial markets.

    Market reactions to anticipated tapering

    Tapering is by its nature gradual (it literally means to ‘lessen’, ‘decrease’ or ‘reduce’), but even the slightest reduction in economic stimulus can have a big impact on markets.

    And although the term tapering is specific to the US and the Fed’s pullback on quantitative easing, a reduction in stimulus by any major economy would have an impact on a broad range of asset classes.

    Uncertainty about when or if a government will start tapering off any stimulus will tend to increase volatility in markets as investors try to predict when and by how much any support will be withdrawn.

    If that economic stimulus has taken the form of bond buying – as in the US – bond prices may fall sharply as investors pull out of that market. This could push up interest rates and, because companies’ lending costs will rise, drive down stock markets.

    Gold prices are sometimes pushed up by economic stimulus – especially if it takes the form of inflationary money printing – so news of any pullback may cause prices to fall sharply. In recent years, however, gold prices have tended to rise when the global economy faces risk, and fall when that risk appears to go away, so that relationship is no longer so simple.

    Currency markets are also very sensitive to tapering talk. In the case of the US, quantitative easing made the US dollar cheaper against the currencies of many emerging markets, such as the Indian rupee and Brazilian real. Tapering talk therefore caused the values of those currencies to suddenly weaken.