written by | November 8, 2022

What is Tapering in Finance and How Does it Impact the Economy?

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Tapering modifies a central bank's monetary expansion policies initiated to stimulate an economy. Tapering often refers to the gradual reduction of quantitative easing (QE) programs. A central bank purchases government securities or other assets to increase the money supply and encourage lending and investment. 

Did you know? Due in large part to India's favourable external position, the US Federal Reserve's decision to taper its asset purchases in November of 2021 had only a "mild" impact on Indian financial markets, whereas it de-stabilised many large economies.

What is Tapering?

Tapering is all about withdrawal from the monetary stimulus program which has been executed and quantitative policies.

The RBI has been reducing the size of its monthly bond purchases under its quantitative easing (QE) program. The RBI has also been raising its policy rates. 

The RBI's Tapering of its monetary policy has been gradual and accompanied by several measures to ensure no sharp increase in interest rates. The RBI has provided ample liquidity to the banking system through its daily repo operations. It has also been conducting open market operations (OMOs) to ensure no sharp increase in bond yields. The RBI's monetary policy actions have been successful in containing the rise in interest rates. However, they have also led to a slowdown in credit growth, which is a matter of concern. it is expected by RBI to continue Tapering its monetary policy in the months ahead.

Process of Tapering 

The process of tapering by the central bank in India is a process whereby the central bank reduces the amount of money it is pumping into the economy. This is done to bring about a reduction in inflationary pressures. The process usually starts when the economy's inflation rate rises and the central bank feels it is necessary to bring it down.

The entire process by the central bank in India can be broadly classified into three main phases. The first phase begins with the RBI giving clear signals about its policy intentions through its various policy statements. This is followed by the RBI gradually withdrawing the accommodative monetary policy measures it had implemented during the global financial crisis. 

The second tapering phase is characterised by the RBI increasing the policy rates. This is typically done gradually and calibrated so as not to disrupt the economic recovery. The third and final phase is when the RBI brings the policy rates back to the pre-crisis levels. This is usually accompanied by a withdrawal of the emergency liquidity measures implemented during the crisis.

Also Read: Know the Difference Between Procurement and Purchasing in Detail 2022

The Need for Tapering 

Tapering is usually done when the economy is doing well and inflation is under control. The central bank will start to sell some of its assets, like bonds, and use the money from the sales to pay down its debt. This process can take months or even years. During this time, the central bank will also stop buying new assets. 

The main reason the central bank tapers are to avoid inflation. If the economy grows too fast, the central bank will print more money to keep up with the demand. This can cause inflation, which is when prices go up too quickly. The central bank wants to avoid inflation because it can harm the economy. 

Tapering is also a way for the central bank to raise interest rates slowly. When the central bank buys assets, it puts more money into the economy. This extra money can cause inflation. To avoid this, the central bank will start to sell assets and raise interest rates. This makes it more expensive for people to borrow money and slows down the economy. The central bank will begin to taper when the economy is doing well, and inflation is under control. The taper will happen slowly and over time so the economy can adjust. The central bank will start to raise interest rates and reduce the money supply. This will slow the economy down and help to keep inflation under control. 

Effects of Tapering 

When the central bank tapers, it slows the growth rate of the money supply. This can have various effects on the economy, depending on the circumstances.  

  • If the economy is already growing quickly, tapering can help to prevent inflationary pressures from building up. It can also help to reduce the risk of asset bubbles forming. If the economy is weak, tapering can further drag on growth. This can lead to higher interest rates and a stronger currency, making exports more expensive and discouraging investment.  
  • Tapering can also have an impact on financial markets. For example, if investors think tapering will lead to higher interest rates, they may sell bonds, pushing up yields. This can have knock-on effects on mortgage rates and other borrowing costs. Ultimately, the impact of tapering by the central bank will depend on the circumstances at the time. If the economy is strong, it can help to keep inflation in check. If the economy is weak, it can further drag on growth. 
  • The effects of tapering by the central bank can be positive and negative. On the positive side, tapering can help to reduce inflationary pressures in the economy by making it more difficult for banks to lend money. On the negative side, tapering can lead to a reduction in the money supply, which can cause a decrease in economic activity and increase unemployment

Also Read: Learn the Difference Between Bookkeeping and Accounting - Changing Faces of Accounting and Bookkeeping

Is Tapering Good?

The RBI's decision to taper its bond-buying program has been praised and criticised by economists. Supporters of the move say that it was a necessary step to avoid inflation, while opponents argue that it could have negative consequences for the economy.  

  • The main argument in favour of tapering is that it will help to avoid inflation. The RBI has been pumping money into the economy through its bond-buying program, and if it had not started to wind down the program, there could have been a danger of inflation getting out of control. By reducing the amount of money it injects into the economy, the bank can help keep inflation in check.  
  • Some argue that it is a necessary step to avoid a financial bubble. With the economy improving, there is a risk that asset prices could start to rise too rapidly, creating a bubble that could eventually burst and cause a recession. By tapering its bond-buying program, the RBI can help to prevent this from happening. 
  • There are also several arguments against tapering. One of the main concerns is that it could lead to a rise in interest rates. The RBI has been keeping rates low to encourage borrowing and investment. If rates rise too quickly, it could lead to a sharp decrease in economic activity. There is also the risk that tapering could cause a decline in the stock market as investors become concerned about the economy's health. 
  • Another argument against tapering is that it could lead to a decline in the housing market. The RBI bond-buying program has been credited with helping to support the housing market by keeping interest rates low. If the RBI begins to taper, it could cause rates to rise and lead to a decline in home prices.  
  • Finally, there is the risk that tapering could cause inflation to rise. The RBI has been working to keep inflation in check, and if the bond-buying program is tapered too quickly, it could increase prices. 

Example of Tapering In India

The Reserve Bank of India (RBI) has gradually reduced the repo rate since February 2019 to revive economic growth. The latest reduction was announced on October 4, 2019, when 25 basis points cut the repo rate to 5.15%. RBI Governor Shaktikanta Das has stated that further rate cuts are unlikely in the near future as the RBI needs to maintain an accommodative monetary policy stance to support economic growth. 

The RBI implements monetary policy by manipulating the repo rate, the rate at which banks borrow money from the RBI. Reducing the repo rate makes borrowing cheaper for banks and encourages them to lend more, boosting economic growth. The RBI has cut the repo rate by 135 basis points since February 2019.

Also Read: Straight Line Method of Depreciation - Straight Line Depreciation Formula

Conclusion

In conclusion, there are both pros and cons to the RBI tapering its bond-buying program. The decision will come down to whether the RBI believes the benefits of tapering outweigh the risks. 

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FAQs

Q: Is tapering beneficial to currencies?

Ans:

Since it signals a shift toward tighter monetary policy, it usually is positive for the currency, since currencies often increase when short-term domestic rates rise.

Q: What does taper in finance mean?

Ans:

In the financial world, tapering is the gradual abandonment of a central bank's quantitative easing program. While QE is intended to increase economic growth, tapering reduces it by slowing down the rate at which central banks buy assets.

Q: What is the rationale behind tapering?

Ans:

The rationale behind tapering is to reduce the central bank's balance sheet size and begin normalising monetary policy after years of extraordinary accommodation.

Q: What is tapering?

Ans:

Tapering is the gradual reduction of central bank asset purchases to normalise monetary policy.

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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.