What is taper and its importance?

On Wednesday, the Fed said taper may come soon if the economy continues to progress, but didn't announce the specific dates.

This should be the biggest news for the financial market. But wait... what is taper and why is it so important？

What is taper?

Before talking about taper, we should know what QE is — the opposite of taper.

When the economy is slagging, the central bank tends to lend more money to the market. This aims to increase consumption and investment, which is a good way to take the sluggish market back to normal.

To lend money out, the central bank can lower interest rates or purchase assets such as bonds from the market. These measures are summarized as QE (Quantitative Easing).

Therefore, the opposite of QE — taper, is taking money back to the central bank, by raising interest rates or decreasing assets purchases.

With rising interest rates, people who are using leverage may choose to sell their stocks because they can't afford the high cost of borrowing. As more people sell, the stock price will fall. As a result, the stock market may react negatively to taper.

How about this time?

On Wednesday, the Fed said the U.S. central bank could begin scaling back asset purchases in November and complete the process by mid-2022. However, after the Fed's announcement, US stocks staged a comeback from their September rout, which is a proof of strong market confidence.

Key Takeaways

1. Tapering is the theoretical reversal of quantitative easing (QE) policies, which are implemented by a central bank and intended to stimulate economic growth.

2. Tapering refers specifically to the initial reduction in the purchasing of and accumulation of central bank assets.

3. As a result of their dependence on sustained monetary stimulus under QE, the financial markets may experience a downturn in response to tapering; this is known as a "taper tantrum."

4. Taper tantrums may lead central banks to promptly re-accelerate asset purchases (and essentially reverse the process of tapering).

5. Central banks, for the most part, have not been able to sustainably unwind their expanded balance sheets.