A central bank is a financial institution with exclusive authority over the creation and distribution of money and credit for a nation or group of nations. In modern economies, the central bank is often responsible for developing monetary policy and regulating member banks.
According to the Reserve Bank of India Act of 1934, the Department of Currency Management is responsible for managing the Reserve Bank’s currency management obligations. Currency management focuses primarily on the issuance of coins and notes as well as the withdrawal of unsuitable currency notes from circulation. The value of the rupee can also be affected by the monetary policies of the central bank. The RBI can alter the repo rate (the rate at which it lends to banks) and the statutory liquidity ratio to maintain control of the currency (the percentage of net time and demand liabilities that banks must put in liquid assets).
What Is Tapering?
When an economy is strained, that is, when the government perceives a liquidity shortage, the central bank purchases a fixed quantity of government bonds and other assets to inject cash into the economy. This is referred to as “quantitative easing.” This recently occurred when the coronavirus pandemic swept the globe, causing all economies to collapse and industry and production to cease. Most central banks, notably the Federal Reserve of the United States and the Reserve Bank of India, have taken steps to stimulate the economy by lowering interest rates and placing more money in the hands of the people.
On the other hand, tapering refers to a banking strategy in which the central bank gradually dials down quantitative easing. Simply put, tapering occurs when the central government stops injecting money into the economy and banks by gradually decreasing its bond purchases in order to wean the economy off the additional support.
Now, tapering is not a novel phenomenon. However, the first time it occurred in a digitally advanced and awakened period (2013), Taper Tantrum, caught the world by storm. As a result of investors’ and stakeholders’ exaggerated response to the government’s announcement of the tapering of the quantitative easing program, the term “tantrum” was coined.
The 2008 financial crisis, which precipitated a protracted recession, resulted in the panic-induced sale of stocks and bonds. The federal government of the United States acted swiftly and launched a large-scale purchase of government bonds as well as other quantitative easing measures. This helped to maintain low loan rates and also increased liquidity in the economy, assuring investors of a brighter future.
The low-interest rates encouraged more individuals to take out loans, which increased consumption and enabled corporations to increase investment. Between 2008 and 2015, the U.S. government injected approximately $4.5 trillion into its economy, a sum that had been only $870 billion between 2007 and 2008.
Noting that injecting capital into the economy to absorb shocks is a short-term solution that can lead to hyperinflation if employed over the long run.
After the U.S. economy showed indications of improvement, the government announced a 2013 reduction in the quantitative easing program. This statement wreaked havoc on the American market, which fell 4% following the release and set off a chain reaction across the globe. Digitally supercharged investors blew it up globally, and global markets began to respond negatively to a factor that should have been anticipated.
Impact on Emerging Economies: As a result of the low lending rates during the QE period in the United States, borrowers were ecstatic while lenders were anxious. Although there was more capital available for lending, the low-interest rates caused the lender’s concern. The additional stimulus delivered to the financial sector must be utilized. Then, American investors began placing capital in Asian markets, including rising nations such as India. The result was an increase in foreign investment in India.
However, when the U.S. Federal Reserve began tapering, American investors in India began withdrawing their funds since higher interest rates in the U.S. gave them a better return on their investments. As foreign investments withdraw, the rupee’s value plummets and depreciates by a large percentage. This requires the RBI to immediately increase interest rates. The strengthening of the U.S. dollar has led to an increase in the incidence of inflation in India. This initiated the phenomenon known as the Taper Tantrum, an investor exaggeration that nearly ruined developing countries.
Not just India, but also other emerging markets such as Indonesia, Brazil, and Turkey, were adversely impacted by inflationary pressures, with the deterioration of their currencies versus the US dollar exacerbating the suffering. Investors feared that this would spark a global panic, but happily, this nightmare did not come true. This does not imply that the markets did not respond.
How Does Tapering Work?
Central banks have a variety of growth-enhancing tools available to them, and they must reconcile short-term economic trends with longer-term market expectations. A recession may ensue if the central bank ceases its activity too rapidly. If it does not reduce its actions, inflation could grow in an undesirable manner.
By being transparent with investors regarding future banking activity, it is possible to generate market anticipation. Therefore, central banks often unwind their loose monetary policies gradually rather than abruptly.
Central banks can lessen market volatility by articulating their tapering strategy and outlining the conditions under which reduction will commence or end. In this manner, anticipated cutbacks are discussed in advance, allowing the market to begin adjusting before the action occurs.
Why Do You Need to Know About Tapering?
In 2013, as US Treasury rates soared, it sparked a multi-month outflow of capital from emerging market economies that started in May of that year. From May 22 to August 30, 2013, the rupee’s value decreased by over 15%. The RBI has to abruptly raise interest rates to stop the withdrawals.
When interest rates on US government bonds are rising, investors are less inclined to invest in riskier assets like equities.
As an investor, it is pertinent to understand the phenomenon such as QE and Tapering because central banks such as the Federal Reserve or Reserve Bank of India, their actions with respect to tapering or quantitative easing are internationally related which affects the investment market across the globe.
The Advantages of Tapering
- Economic regulation: Tapering aids in lowering inflation and inflation expectations while cooling an overheating economy.
- Price Stability: By balancing supply and demand across all markets, including the labor and housing markets, tapering aids in the achievement of price stability.
- Stronger Dollar: A tighter Fed policy often strengthens the U.S. dollar relative to other currencies, making imports and foreign trips more inexpensive for U.S. citizens. Since there is an inverse relationship between the U.S. dollar and global commodity prices, tapering should, in theory, bring down commodity prices. However, this affects the economies of several countries.
Disadvantages of Tapering
- Higher interest rates: Tapering, especially if followed by additional tightening measures, can be expected to precede rising interest rates. As a result, borrowing becomes more expensive, and economic growth is delayed.
- Weakened economic indicators: The GDP, the employment rate, and consumer confidence can all be negatively impacted by tapering.
Impact of Tapering On Stock Market
Following the 2013 tapering, investors expected a stock market catastrophe. Nevertheless, the impact was minimized and, thankfully, limited. As tapering began in the United States, bond yields and interest rates began to increase. The U.S. stock market fared excellently, although the impact on Indian markets was negligible. From 2013 to January 2020, the Sensex grew by 105 percent (just before the pandemic).
Critics of QE fear asset price bubbles since the values of financial assets—particularly debt instruments like bonds, but also stocks—are inversely related to interest rates. Low borrowing rates and low returns on financial assets may have contributed to speculative bubbles in physical assets like real estate. Similarly, QE may result in an increase in the flow of funds into cryptocurrencies. If tapering actually raises interest rates, speculative bubbles supported by historically low-interest rates may implode.
Significance Of Tapering On Economy And Market
The policy of tapering is the opposite of quantitative easing (QE). It occurs when the government progressively discontinues its quantitative easing (QE) policy. For instance, the US government currently makes monthly asset purchases of $85 billion. Tapering would occur if the US government reduced its asset purchases from $85 billion to $60 billion the next month.
The Federal Reserve System, also known as the “Fed”, has been debating tapering for the last few years. But even a passing suggestion of curtailing quantitative easing (QE) sends the markets tumbling. For this reason, the Fed usually holds off and attempts to find a better solution and window of opportunity to handle the predicament.
In both American and international markets, the tapering strategy has been heavily discussed. This is due to the fact that it is both the most significant and the least common monetary policy in existence today. This policy’s scope is what gives it this level of significance. A long-lasting and significant impact on a range of economic parameters will result from how this policy’s ramifications play out.
Interest Rates: The tapering’s most significant effect will be felt in interest rates. The effect virtually happens instantly. In fact, quantitative easing (QE) is typically implemented when interest rates are already at zero but the central bank wishes to offer more stimulus. Hence, quantitative easing (QE) can be thought of as a sub-zero interest rate policy. Thus, when implemented, the quantitative easing (QE) strategy decreases interest rates. Since it has been available on the market for the last few years, consumers have become accustomed to it. Thus, it is anticipated that when tapering is implemented, interest rates will rise. This is because lenders will need to ration their lending because of a constrained money supply. They will lend money to whoever can give the greatest interest rates, and as a result of this competition, interest rates will surge.
Inflation and Deflation: The policy of quantitative easing (QE) is inflationary. This is because it essentially expands the monetary base in the economy. Therefore, when there is a greater supply of money chasing relatively fewer goods, inflation happens and prices rise. The United States has seen three rounds of significant quantitative easing (QE), and as a result, prices are significantly inflated as compared to what they would have been otherwise.
Consequently, when the opposing policy of tapering is applied, deflation is likely to occur. This is due to the fact that tapering removes money from the system. As a result, there is now less money (as compared to before) chasing the goods available, making goods less expensive.
Employment: Generally, the state of inflation or deflation in the economy has a significant impact on the employment rate. Economic confidence is high, and more goods are produced when there is excess money in the economy. As a result, an increasing number of individuals are working in the economy. Therefore, there is a positive correlation between increased employment and quantitative easing (QE).
Contrarily, when there is less money in the economy, consumer confidence is low, people are buying fewer items, and as a result, producers are manufacturing fewer items. Thus, a decline in the money supply leads to a decline in employment levels. Thus, a policy of tapering leads to lower employment levels.
GDP: Gross Domestic Product or GDP is the total value of goods produced and services provided in a country during one year. Therefore, there is a direct relationship between the amount of money in circulation and the Gross Domestic Product (GDP). When quantitative easing (QE) is undertaken, an economy’s GDP increases and it enters the peak phase of the economic cycle. On the other hand, when the tapering program is implemented, the GDP of an economy decreases, causing it to enter a recession.
Asset Prices: Any economy’s money supply is linked to its asset prices. Everybody in the economy has greater purchasing power as the money supply rises, which often leads to rising asset prices. In contrast, asset prices tend to deflate when the money supply declines. This is precisely what is projected to occur if tapering occurs.
Frequently Asked Questions (FAQs)
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What is Quantitative Easing (QE)?
Quantitative easing (QE) is a sort of unconventional monetary policy in which a country’s central bank, like the Federal Reserve, makes significant open market purchases of long-term securities in an effort to boost the economy by increasing the money supply and promoting lending and investment.
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What does “tapering” mean?
In finance, tapering refers to the gradual reversal of a central bank’s QE plan. While QE is intended to increase economic growth, tapering slows down economic growth by reducing the pace of a central bank’s asset purchases.
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