INSIDE INVESTOR: Navigating the year of the taper

At this point, Federal Reserve tapering is scheduled to begin gradually later this year. But don't be surprised if that changes.

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What is the taper? And why is it so important?

When the head of America’s central bank talks about tapering, he is referring to the gradual winding down of the massive economic stimulus program that has kept the world’s biggest economy afloat for the past four years.

America essentially has been printing money to fuel demand and get the economy back on track in the wake of the global financial crisis.

More than $US85 billion a month is being pumped into America’s economy. And it is being done by the US Federal Reserve’s purchase of US government bonds.

Those purchases have pushed up bond prices and thus kept interest rates artificially low. The knock on effect of that is to depress the US dollar which, in turn, has pushed the Australian dollar higher than it otherwise should have been.

News of the gradual unwinding of that program, or tapering, has sent shockwaves through the market; an unintended consequence of the announcement.

While the US Fed chairman Ben Bernanke was attempting to slowly acclimatise investors to the idea of a gradual wind down of the stimulus into 2014, he misunderstood the nature of markets.

Financial markets try to anticipate the future. Every investor on the planet wants to be one step ahead of the pack. So, while in theory investors should have gradually readjusted their portfolios as the stimulus was gradually turned off, the opposite actually occurred.

Traders and investors rushed for the exits. Emerging markets and commodity prices fell. Gold prices fell faster and further than at any other time in history and the Australian dollar dropped 12 per cent in the space of six weeks.

In fact, it all happened a little too quickly for America’s economic overlords. US interest rates jumped by about 1 per cent and the greenback shot higher against most major currencies. That’s despite the stimulus still proceeding at full speed.

Such a reaction could damage the tentative recovery now underway in the US. So, not surprisingly, Bernanke and his Federal Reserve cohorts have since begun to demur on the timing of the tapering.

At this point, it is still scheduled to begin later this year and gradually wind down to zero some time in 2014. But don’t be surprised if the dates are pushed back. One thing is for certain, tapering has taken on an entirely new meaning and it will be continually mentioned in the year ahead.

What is the taper? And why is it so important?

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