Bernanke may opt for mild taper. Raghuram Rajan may hold rates steady

After a topsy-turvy couple of months when the US Federal Reserve (US Fed) chairman, Ben Bernanke announced a tapering off plan for their $85-billion-a-month bond buying programme, the global equity and commodity markets are now at a crossroad. The outcome of the US Federal Reserve’s September 17 – 18 meeting currently underway will be known in a few hours and will go a long way in determining the road ahead for the markets.

Closer home, the Reserve Bank of India (RBI) will review its Monetary Policy a day later, and to a large extent will be dependent on the outcome of the US Fed meet.

Most market participants expect the US Fed to opt for a mild taper – around $10 billion or less, which the markets have already factored in.

“The current market consensus is that the central bank will start tapering its third quantitative easing programme by between $5 – 15 billion. A form of light tapering will be announced as a compromise between two camps in the Fed: the first calling for tapering, while some other members of the committee may want to hold off on tapering, out of fears that the recovery is still in a fragile stage,” points out Philip Marey, senior US Strategist, Rabobank Financial Markets Research.

“This amount of tapering has by now been priced in by the markets, so the impact of such a move might be limited. Bernanke could further reduce the impact on rates by not announcing a specific path for tapering, and by stressing that there is symmetric flexibility of further tapering,” he adds.

Anindya Banerjee, currency analyst, Kotak Securities believes there is a strong case for US Fed to start reducing the monetary accommodation in a phased manner, as it was originally seen as a contingency plan to counter-act the tail risk in Euro zone and negative effects of feared US Fiscal cliff, end of last year.

“There is growing recognition that QE as tool to promote economic growth is losing its effectiveness and also creating the risk of financial imbalances. However, along with tapering of liquidity, one must also focus on the tone of the forward guidance on interest rate outlook from the US Fed. ncase, Fed does not change the language to dovish and does a taper between 10-15 billion, Indian Rupee could come under pressure,” he says.

As a safeguard mechanism to curb currency volatility in the light of financial market and capital flow volatility, BRIC (Brazil, Russia, India, China and South Africa) nations have already planned a $100-billion currency reserve fund (CRF). While Brazil, Russia and India have agreed to contribute $18-billion each, China will shell out $41-billion and South Africa will contribute $5-billion.

Edward Teather, executive director and senior economist, UBS Investment Bank expects US Fed to announce a tapering of its quantitative easing (QE) programme. “We expect the tapering to be in the order of $10 billion-a-month. Since the current bond buying is around $85 billion-a-month, the entire taper could easily take eight – nine months to wind down,” he suggests.

RBI's Monetary Policy review

On the domestic front, the RBI will review its Monetary Policy – the first by the under the new governor, Raghuram Rajan.

Given that the US Fed’s statements on the taper plan would just be a day old and could take some time to play out, Rajan may still want to wait-and-watch before calling the shots.

“Uncertainty regarding the tapering of quantitative easing by the US Federal Reserve and mixed cues provided by recent domestic macroeconomic data have complicated monetary policy setting. Caution is warranted as external events and domestic political uncertainties may exacerbate FII outflows and intensify currency volatility. As a result, we expect the RBI to maintain the marginal standing facility (MSF) rate at 10.25% in the upcoming policy review,” suggests Naresh Takkar
MD and CEO, ICRA.

“We think that the RBI is unlikely to increase the repo rate as a measure to attract FII debt inflows, as a rate hike would dampen domestic growth prospects. At the same time, a rate cut to boost sentiments seems unlikely in the mid-quarter review, in light of the uptick in headline inflation and widening under-recoveries on the sale of diesel,” he adds.

“The RBI is likely to maintain status quo on policy rates as well as liquidity tightening measures announced in July 2013. Though one can glean some early signs of stability on Balance of Payments (BoP) and INR fronts, we believe reversing the liquidity measures in the forthcoming policy would be hasty. In our view, the central bank will wait to get more clarity on the impact of FOMC decision on global capital flows and gain more confidence with regards to the trade deficit trajectory,” suggest Kapil Gupta and Toshi Jain of Edelweiss Research in their recent report.