Fighting the taper
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Volatility is inevitable. India should prepare its response to the winding up of QE
The dominant theme at the annual meeting of central bankers and economists last week at Jackson Hole, Wyoming, was the impact of Quantitative Easing (QE) tapering on emerging markets (EM). Central bankers from emerging economies pressed Fed officials to consider the volatility in emerging economies arising from changes in the Fed's monetary policy stance. But Fed officials reminded them that their mandate was only to serve the US economy. Emerging markets would have to adjust.
Knowing that the world will be a more volatile place gives us time to prepare. India's policy response to QE tapering should be prepared in advance so that we do not see more of the kind of knee-jerk reactions that were seen last month. It is expected that September may see more forward guidance by the Fed, rather than actual tapering. The pace and timing of the tapering are likely to remain uncertain for many months. This could result in huge volatility in global financial markets. One important question for India will be whether to respond to the pressure on the currency and if so, how.
First, let us look at what lies ahead. The objective of the US Fed's monetary policy is to maintain price stability and achieve maximum employment. The Federal Open Market Committee is responsible for taking decisions on how to achieve these objectives. In normal times, this was done by cutting or raising the policy interest rate. On December 16, 2008 the policy interest rate was cut to the lowest possible level of 0-0.25 per cent. After this, there was no scope of cutting interest rates and the Fed eased monetary policy by purchasing financial assets, thereby stimulating growth, popularly known as QE. The Fed announced its first round of purchases in November 2008 and started buying bonds from March 2009. There have subsequently been two more rounds of QE, in 2010 and then in 2012, as the US economy did not show signs of recovery. The Fed is currently buying $40 billion of Mortgage Backed Securities and $45 billion worth of US treasury bonds per month. Tapering refers to a reduction in the purchase of such securities by the US Fed.