Taper without tantrum

Fed pivots on policy, but calm reigns

The United States Federal Reserve, led by recently renominated Fed Chair Jerome Powell, shifted its monetary policy stance in its meeting this week. The Fed’s governors announced that the US central bank would accelerate the rate at which it is tapering off its purchases of assets for its balance sheet. Mr Powell also signalled that there was debate in the committee for the first time on how and when the Fed would begin to shrink its vastly expanded balance sheet, thereby withdrawing liquidity from the global economy. This may be some distance in the future, but it is a clear change in stance — even perhaps something of an abrupt pivot. Asset purchases will end months earlier than expected, probably by mid-March, after which rate increases will likely begin. Most of the Fed’s decision-makers expect that there will be three such increases in 2022.

Global markets, however, reacted with relative calm. Some of the Fed’s concerns were already priced in, and the pace of withdrawal, although accelerated, was not startling. Some market observers noted that it was unlikely to immediately cause vast cross-border flows because the real interest rate in the United States will likely remain negative through all of 2022. Yet there are reasons nevertheless for countries in the emerging world, including India, to take note. For one, it is clear that the Fed has been burned by its complacency about inflation, which is reaching new heights in many parts of the developed world. If inflationary expectations become unanchored in the United States and elsewhere, then the Fed might feel pressure to further advance its calendar for monetary tightening.
 

As compared to the last time that a “taper” was discussed almost a decade ago, India can feel more secure about its external account. While many commodity prices are high and volatile, they have not reached the stratospheric levels of the past. Indian macro-economic fundamentals, in spite of the unprecedented effects of the pandemic, look considerably better than those of its emerging-market peers, and the dollar reserves are comfortable. Long-term bond yields in India, at 6.38 per cent on Thursday, have a comfortable cushion over the short end. Yet the Reserve Bank of India, which has been accommodating the government’s fiscal requirements for some time now, will also be cognisant of a new reality. A sustained divergence between tightening policy in developed markets and monetary looseness in India will put pressure on the exchange rate, exacerbating inflationary forces in India. The dollar-rupee exchange rate stayed below 76 to the dollar, even as a data release revealed that the RBI sold $100 million worth of foreign exchange in the spot markets over the course of October. The central bank no doubt knows better than to use reserves to fight a structural decline in the value of the currency caused by policy divergence.

The Union government, entering the period in which it prepares the Budget, should also keep the future drain of global liquidity and its effect on borrowing costs in mind. Finally, equity markets in the US and other developed countries responded generally positively to the Fed. Clearly, the news of an accelerating taper was not the long-expected signal for a correction in relatively expensive Indian equities. There was a mild sell-off prior to the Fed announcements, but restored risk appetite and good results for information technology firms pushed indices upward at Thursday’s close. Yet the fact is that foreign money has been leaving the markets for three months, and given the new climate signalled by the Fed, sustained domestic buying will have to make up the difference for the foreseeable future.