Tapering and its Consequences.

The U.S. Federal Reserve has announce his long awaited tapering of its massive assets purchase program, known as Quantitative Easing. The program involves massive purchase of long term maturity bonds by the fed with an aim to keep the long term interest rates low. Thus the fed hoped that the low interest rates would encourage consumers to start spending and industries to grow.

Till now through successive enhancements to its bond buying program, known as QE1, QE2, and QE3, the fed had committed to buy $85 billion dollar of treasury and mortgage securities every month. The latest move reduced such purchases by $10 billion to $75 billion dollar.

Reasons for Fed’s decision to undertake such unprecedented bond buying is that the economy failed to respond favourably even after lowering of policy interest rates to near zero following the economic crisis in 2008-09. Therefore Fed resorted to expansion of reserve money through its bond purchase program.

The Fed 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, 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. 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 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. 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).

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.

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.

Courtesy:

C. R. L. NARASIMHAN