In a long awaited decision, the U.S. Federal Reserve recently announced the commencement of the tapering of its massive asset purchase program, widely known as quantitative easing (QE).
The programme has involved massive purchases of long maturity bonds by the Fed, with an aim to keep long-term interest rates subdued. The Fed hoped this would cajole industry and consumers alike to kick-start economic activity.
Till now, through successive enhancements to its bond buying program, known as QE1, QE2 and QE3, the Fed had committed to buy $85 billion of treasury and mortgage securities every month. The latest move reduces such purchases by $10 billion to $75 billion.
Reasons for Fed’s decision to undertake such unprecedented bond buying in the first place are well documented. As the economy failed to respond favourably even after lowering of policy interest rates to near zero following the economic crisis in 2008-09, the Fed resorted to expansion of reserve money through its bond purchase program.
While extending its bond purchase program for a third time, announced as QE3 in September, 2012, the Fed, which has a statutory mandate to foster employment and maintain price stability, noted that in the second half of 2012, economic activity in the U.S. has been expanding only at a moderate pace. Unemployment rate still remained elevated, and growth in employment slow.
Growth in business fixed investment had been sluggish. Inflation remained subdued and long-term inflation expectations have remained stable. Without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labour market conditions. The Fed also noted that global financial markets, dependent as they are on the U.S. policy actions, have been under stress. Inflation, over the medium-term, would run at or below 2 per cent. Hence, a further increase in stimulus in the form of QE3 was necessary to support stronger economic activity and reduce unemployment so that over time inflation remains at the rate most consistent with its dual mandate.Specific milestones
It is clear that Fed’s quantitative easing has solely been for the benefit of the U.S. economy to stimulate it after the recession. The decision to phase it out or persist has always depended on the circumstances in the U.S. It is, therefore, not surprising that right from the beginning, the Fed had laid out specific milestones relating to U.S. employment and inflation on attaining which it would contemplate withdrawal.
The programme has had major consequences not only for the U.S. economy but even for India and the rest of the world. As a corollary, its tapering would too, though it has to be seen as the beginning of its phase out and not as an abrupt termination. In a globalised world, the reasons why such a U.S.-centric move came to mean so much to the rest of the world are not far to seek. With capital barriers progressively being lowered in a fast globalising world, the flood of money released through bond purchases sought and found investment opportunities providing higher returns wherever possible, of course, mindful of the risks involved.
Countries too, in need of capital to fund their own growth, welcomed such capital. Not surprisingly, Indian stock markets absorbed some of those flows. According to one reliable estimate, around $31 billion of FII money was invested in the Indian stock markets since QE2 began. Pertinently, given that India was registering large current account deficits for most of this period, these short-term flows assumed crucial significance for balancing the country’s BoP (Balance of Payment).Global significance
The world was reminded again of the global significance of the U.S. monetary policy when a mere suggestion by the Fed in May that it would begin tapering its bond purchases wreaked havoc in developing economies. India, thus far cushioned by short-term capital flows, saw a free fall in rupee to reflect its large current account deficits and fear of pull out by FIIs as well as diminishing growth prospects.
However, Fed’s subsequent decision in September to postpone the taper came as a welcome breather for markets everywhere, including India. Stock indices everywhere retraced their fall. The rupee, which had lost more than 11 per cent since May, bounced back, not least with the help of a narrowing current account deficit and the Reserve Bank of India’s efforts to shore up forex reserves.
When the Fed eventually announced its decision to taper in December, the response was much more muted with the world seemingly better prepared this time, just three months after the earlier scare. India too seems better prepared.
In conclusion, it is useful to emphasise that the U.S. monetary policy is framed with reference to the U.S.
There has, however, been a fond hope, expressed by the IMF among others, that rich nations would dovetail their stimulus withdrawals with the policies of developing countries.
A few lessons have been learnt as well. In India, the latest RBI policy statement took note of the risks arising out the U.S. decision to taper but emphasised on the need to set the internal determinants of the economy in order. It goes without saying that capital flows would seek better risk-adjusted return.
The commencement of the taper is a definite indication that the U.S. economy is improving, and, therefore, opening to more investment opportunities. Therein lies an important message for India.
A stronger U.S. economy is good for India in many ways. There are greater possibilities for exports, technology transfer and, most important of all, a timely reminder for India to set its house in order and, therefore, attract larger, more stable foreign flows. Irrespective of the short-term consequences of the taper, a stronger U.S. economy is a blessing for the global economy.