What is Taper Tantrum – Its Impact and How to Central Banks do It
When an economy is under stress and facing a liquidity crisis, the government seeks to boost the economy via quantitative easing (QE) scheme. The term Taper Tantrum stems from the collective reactionary panic against the sudden spike in US treasury yields in 2013 when investors got to know that the Federal Reserve was slowly putting the brakes on its quantitative easing (QE) programme.
This blog talks about the causes, impact and significance of taper tantrum. Let’s dive in!
What is Tapering?
In financing, tapering is the withdrawal of a completed quantitative easing programme to stimulate the economy. During a quantitative easing programme, a central bank of a country purchases a specific amount of government securities, bonds or other financial assets from its member banks.
This pumps money into the economy which stimulates economic activity and boosts recovery. It changes the fiscal expansion policies by the central bank and triggers the economy.
After the quantitative easing policies stabilises the economy, the tapering is executed, which may include cutting back central bank’s asset purchases. These programmes are gradually unravelled once the policy maker is satisfied that the goals are attained i.e. self-sustaining economic growth.
What is the Taper Tantrum?
The taper tantrum refers to a period of market turmoil that occurred in the spring of 2013, when the US Federal Reserve announced that it would begin to taper, or reduce, its program of asset purchases, known as quantitative easing.
The announcement caused a sharp sell-off in the bond market and a significant increase in interest rates, leading to a period of market volatility and uncertainty.
The taper tantrum highlighted the sensitivity of financial markets to changes in monetary policy and served as a reminder of the importance of clear and effective communication by central banks.
What is the Significance of Taper Tantrum?
When US Treasury yields climbed dramatically in 2013 as a direct result of tapering, it caused a financial drain from developing or emerging market countries that lasted several months.
Foreign institutional investors withdrew funds from both equities and bonds in India. Between May 22 and August 30, 2013, the value of the Indian currency decreased by more than 15%. To curb the investment outflow from the Indian markets, the RBI abruptly raised interest rates.
The taper tantrum highlighted the sensitivity of financial markets to changes in monetary policy and served as a reminder of the importance of clear and effective communication by central banks.
How Does the Central Bank Do Tapering?
Central banks have numerous resources to control monetary policy, manage financial fluctuations and control the health of the economy. The central bank can introduce policies like quantitative easing where they buy assets from their member banks while keeping the interest rate low to return the money to the economy.
However, the money cannot be injected into the economy indefinitely. When there has been adequate economic recovery the central bank can reduce asset purchases and start withdrawing the QE or quantitative easing programme. This phenomenon is known as tapering.
If the bank decreases its bond purchases, bond demands fall in the future. As a direct result, bond prices fall while yield climbs. Central banks can control market volatility by using the tapering scheme and conveying the circumstances under which reduction will happen.
Effects of Tapering on the Stock Market
The news of tapering in 2013 was expected to create a drastic change in the stock market, but the effects of tapering were minimal and brief. When tapering began in the US, the bond yields and interest rates began to increase. For example, the ten-year US Treasury yields climbed from roughly 2% in May 2013 to around 3% in December 15.
The US stock market performed well and didn’t fall as expected. For one, following the announcement the Fed did not actually slow its bond-buying QE programme. In fact, they ended up buying additional bonds worth $1.5 trillion 2015. Another reason is that the Fed believed in the recovery of the market.
As a result, investors’ morale was improved, and expectations of the investors were managed by periodic policy announcements. The financial markets re-stablised as investors realised there was no need for concern.
Impact of Taper Tantrum on India
In 2008 the financial markets were affected globally. The phenomenon of taper tantrum nearly crippled developing economies. Foreign investors started to invest in emerging economies like India. But when the taper tantrum ensued in 2013, the bond yield increased in the US and became a more attractive investment than emerging markets bonds and assets. Foreign institutional investors started to withdraw funds from both equities and bonds in India.
Tapering caused a global panic about rising credit costs, causing significant capital outflows from emerging markets. Between May 22 and August 30, 2013, the value of the rupee fell by more than 15% causing India’s inflation to rise. To solve this issue the RBI had to abruptly raise the interest rates.
In 2020 when the US started the QE program again on account of Covid-19, there was not a significant investment surge in the Indian market. Hence in the case of tapering there wouldn’t be much risk of taper tantrums. After the announcement of tapering recently there was no significant impact and the market fluctuated by 1% only which can be recovered in no time without denting the economy.
Impact of Taper Tantrum on Investors
During the 2008 financial crisis, the US Fed implemented the QE programme and purchased many securities and bonds to inject cash into the economy. They started purchasing government bonds and assets back in 2008 and once again in 2020 during a pandemic.
The federal government had recently bought bonds and securities worth $120 billion. And once again when the economy recovered after a severe hit during the pandemic the central bank announced the implementation of tapering.
A taper tantrum can change the strategies used by investors as yield bonds rise. For example, back in 2013 when bond yields rose in the US, it became a more attractive and lucrative option than emerging market assets. As a result, investors started to invest in the US market and capital flowed out of the emerging markets.
Final Word
The taper tantrum of 2013 caused emerging-market volatility due to the significant withdrawal of investors from their markets and currency depreciation among these nations. Many of them have improved their external balance sheets since 2013, making them substantially less sensitive to Federal Reserve tapering today.
FAQs
Ans. Tapering is the process by which the Federal Reserve reduces economic stimulus by reducing the speed at which it purchases assets. In November 2021, the Fed began to taper its current bond-buying programme. Tapering is a method of gradually reducing quantitative easing while maintaining economic recovery.
Ans. A taper tantrum is an investor reaction to the unexpected news that the Fed will reduce bond purchases. The word was coined in 2013 in response to the Fed’s statement that it would be tapering bond purchases in the near future.
Ans. Tapering alters monetary expansion policies launched by a central bank to stimulate the economy. During a quantitative easing programme, a country’s central bank may purchase asset-backed securities from its member banks, pumping money into the economy and boosting recovery.
Ans. During the 2013 ‘taper tantrum,’ international institutional investors withdrew money from both shares and bonds in India. Between May 22 and August 30, 2013, the rupee fell by more than 15%.
Ans. As the Fed purchases more assets, the market for bonds becomes more constrained. Existing bonds’ prices will rise as a result. Because bond prices and interest rates are inversely connected, this leads longer-term interest rates to fall.
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