What is tapering and what is the connection with the latest drop?

What Is Tapering?

Tapering is basically a policy that is implemented by central banks. Through tapering, a central bank can adjust its monetary expansion policies, which were put in place by the FED to stimulate the economy. As part of a program known as quantitative easing, a nation’s central bank may buy asset-backed securities from its affiliated banks in order to inject money into the economy and quicken the recovery process.

Following the stabilization of the economy brought about by quantitative easing (QE), tapering must be initiated, which may involve modifying the reserve requirements or interest rate. Additionally, the Federal Reserve will reduce the amount of US assets it holds.

What are the effects on the stock market?

Central banks may be reluctant to shrink their QE (quantitative easing) programs due to “taper tantrums,” which take place when investors and the financial markets overreact to a decrease in central bank stimulus.

Tapering usually affects the markets badly. Since companies like to use cheap money, taking cheap money out of the market makes those companies invest less. Thus, making their stock price go down.

However, continuing to provide cheap credit to boost the economy after a recession has ended can lead to inflation going up and asset price bubbles that are fueled by monetary policy.

Warnings of impending central bank tapering are frequently accompanied by sharp increases in government bond yields and falls in equity markets, which encourages monetary policymakers to postpone plans to unwind their balance sheets in order to protect the interests of their financial sector stakeholders.

What distinguishes the two terms “tapering” and “tightening”?

A central bank may implement a tight or contractionary policy in an effort to moderate inflation when it is increasing too quickly, slow down economic growth when it is perceived to be accelerating too quickly, or both. By altering its policies on the discount rate, often known as the federal funds rate, the Fed can tighten monetary policy by increasing short-term interest rates. Additionally, the Fed may engage in open market operations to sell assets on the balance sheet of the central bank to the public (OMO). However, the transition between the expansionary and contractionary monetary policy is referred to as tapering.

When should tapering start?

Quantitative easing (QE) is one of the techniques the Fed uses to boost the economy. QE policies must be gradually discontinued once the anticipated effects of an economic stimulus program have been realized because, like all other stimulus programs, they are not meant to be permanent. A central bank’s rapid operational adjustments can cause the economy to enter a recession. Inflation may rise if a central bank never modifies its economic stimulation measures. Prior to an increased expansion toward inflation, when the stimulus has taken effect, there is a tapering period.

What happened in 2022? And what is the connection with the drop we saw with tapering and tightening?

As of today, the market benchmark S&P 500 went down around seventeen percent. People who follow our article series “the AP on the Street” would know what the main reason for it was. The main reason was basically the tapering period and the following tightening cycle. It is quite a similar pattern to the recessions we had before, like during Volcker’s era and the great recession.

Board of Governors of the Federal Reserve System

This does not mean we will have a recession now, but it might be a catalyzer, as several big banks also predicted.