The United States Federal Reserve plays a key role in maintaining a stable economy.

Also known as the Fed, the central bank system controls inflation levels, ensures maximum employment, and maintains high production output of goods and services.

During a financial crisis, achieving this balance becomes even more challenging.

But this level of support can’t go on forever, and the Fed must eventually dial it down through a process called tapering. But when is the right time to taper? And what’s the market impact?

This is Tapering, Unpacked.

Quantitative Easing is an unconventional monetary policy. It was first implemented in the U.S. during the Global Financial Crisis when traditional policy rates fell to zero – which had never happened before.

With QE, a central bank buys a large amount of assets from the market each month to jumpstart economic activity.

The Fed started another QE program in response to the fallout from the COVID-19 pandemic.

Even though the Fed cut interest rates to zero, the overall recovery was weak, and inflation remained too low. It was clear that additional monetary stimulus was needed.

Each month, the Fed purchased billions in government-backed bonds. This created an additional source of demand. More demand means a higher price for debt securities and, as a result, a reduced yield.

Lower long-term interest rates make it cheaper to invest in houses and cars, which helps the economy.

Fewer bonds in the market also cause investors to rebalance their portfolios by buying other types of assets – easing financial conditions and boosting economic activity.

For each month starting March 2020, the Fed committed to purchasing assets at the pace of $120 billion dollars. While the Fed can carry this debt on its balance sheet, a program of this magnitude isn’t sustainable.

To determine when to scale back, the Fed looks at two main indicators: inflation and employment.

In a crisis, the Fed generally cuts interest rates to reduce the cost of borrowing and boost consumer spending.

When the economy is growing, businesses tend to increase prices and the Fed typically raises interest rates to cool the economy – and prevent inflation from going too far above the threshold.

The Fed‘s annual inflation target is a two percent rate which helps keep the economy stable.

While it’s normal for inflation to fluctuate, there can be extreme spikes with economic downturns and recoveries. During the COVID-19 pandemic, inflation dropped close to zero. Then, as the economy reopened after the government shutdown, inflation climbed to more than five percent.

When it comes to employment, the Fed looks for several indicators of a healing labor market.

While it’s normal for inflation to fluctuate, there can be extreme spikes with economic downturns and recoveries. During the COVID-19 pandemic, inflation dropped close to zero. Then, as the economy reopened after the government shutdown, inflation climbed to more than five percent.

For example: regaining jobs close to the pre-crisis employment level is dependent on whether minority groups are sharing equitably in job gains… whether there are more full-time opportunities than part-time…and whether wages have improved.

Once the labor market has progressed enough, the Fed will determine when, and how much, to begin tapering.

Its goal is to slowly reduce the pace of purchasing assets rather than going straight to zero - potentially leading to a jump in longer-term interest rates and market volatility.

Communication on tapering from the Fed is critical for the market.

The market is constantly anticipating what’s to come. So the more information the Fed has, the more it’s able to price major events in to the cost of an investment.

As the inflation and employment data evolve, the market will change its assumptions on how the Fed will taper.

If the Fed is successful in communicating its thinking along the way, the risk of market volatility is minimized – unlike the 2013 Taper Tantrum.

Following the 2008 Global Financial Crisis, three rounds of Quantitative Easing took place between 2009 and 2012.

In 2013, as economic recovery was underway, the Fed commented on its intention to slow its pace of asset purchases earlier than the market had anticipated.

The comment came as a surprise. The markets assumed that the Fed would raise interest rates much sooner.

This all led to heightened volatility that hurt global markets and as a result, the Fed delayed their timeline for tapering by several months.

While tapering is an unconventional policy that doesn’t happen often, it will continue to serve as a critical strategy for how the Fed operates in the market - helping the economy find a way back to stability during turbulent times.