When talking about tapering in finance, reference is made to the gradual reduction of the extraordinary expansionary monetary policy measures taken by central banks after an economic crisis.
In the financial vocabulary, “taper” in English means to decrease and the use of this word in finance is faithful to its original meaning.
It was initially used to talk about the withdrawal of monetary stimuli by the FED in 2013, although later it was also used to refer to the reduction of expansionary monetary policies by any central bank.
The origin of the word tapering lies in the reduction of the extraordinary measures taken in the United States against the 2008 crisis. For example, the gradual reduction in the purchase of bonds by the FED (a purchase of 80,000 million dollars per month -the famous quantitative easing).
Said purchase of bonds was also a measure applied in other central banks since the beginning of the 2008 crisis, such as the European Central Bank, the Bank of Japan or the Bank of England.
Strong monetary stimuli were also applied after the covid crisis in 2020 by the vast majority of central banks in the world.
Given the enormous magnitude of the financial stimulus, the reduction process is very important. If central banks apply aggressive and expansionary stimulus, they must act accordingly later. That is, make a gradual withdrawal to avoid the rebound effect.
Why is tapering applied
When a central bank applies monetary stimulus measures (expansive monetary policies), to get out of an economic crisis (such as the great recession of 2008, or the covid crisis) this can cause economic distortions.
One of the main economic distortions, and one that scares economists the most, is that inflation increases considerably and over a long period of time. Let us remember that expansive monetary policies have increased the money supply of a country or region, so as there is more money in circulation, the value of money may fall and therefore the prices of goods and services rise.
To prevent prices from spiraling out of control (among other economic distortions), the central bank must withdraw monetary stimulus measures, ie tapering must begin.
Monetary policy measures are gradually being phased out as the main data on the economy show improvements (increases in GDP, contained inflation of around 2%, reductions in unemployment).
It must be done slowly to avoid major distortions in the financial markets. If the tapering was done too quickly, it could be detrimental to the economy, since they were measures applied to get out of an economic crisis. By reducing the money supply (or actually increasing it less) the liquidity of the economy can decrease, reducing the credit granted by banks and investors, this in turn being able to cause falls in the prices of assets (such as stock markets and real estate) . What can lead to another economic crisis.
However, if it is the monetary stimulus that starts to cause economic distortions (for example high and prolonged inflation), the central bank will be forced to apply the tapering more aggressively, since the monetary stimulus may be causing economic bubbles. , causing a major crisis.
How does tapering affect financial markets?
Tapering consists of withdrawing the monetary stimulus, so it is basically a reduction in the money supply, or rather a smaller increase in the money supply with respect to the rate of increase that was previously stimulating it.
The markets, speaking colloquially, are interested in having more money in circulation so that prices increase. Therefore, the stimulus measures are welcome, as long as they do not provoke an economic bubble, which causes an economic crisis (as happened with the 2008 crisis after the monetary stimuli of the early 2000s and the real estate bubble that they created ).
Conversely, tapering, which involves reducing stimulus, can have bad consequences for financial markets.