Column: After the taper, what?

Sep 18 2013, 03:32 IST
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SummaryThe Fed will likely signal a median interest rate forecast of 2.25% for end-2016 with a first rate hike in 2015

And so the day of reckoning has come. This week, the US Fed will show its hand on tapering quantitative easing (QE). Since late May, fears of tapering have already spiked both the US and global interest rates and played havoc with assets and currencies of emerging market (EM) economies with current account deficit. While the size of the first reduction in the Fed’s current monthly $85 billion of asset purchases will be the key decision to watch, equally important will be whether the central bank changes communications to anchor rate hike expectations and stop the market from conflating tapering with interest rate policy. The market is pricing that once tapering is over, a hike in Fed’s overnight rate won’t be far behind. The Fed has been trying hard to convince the market that the two are unconnected. Complicating all of this is last weekend’s withdrawal of Larry Summers as a candidate for the next Fed Chairman, making Janet Yellen, well known for her dovish views on policy, to be the leading contender.

Does any of this really matter?

Isn’t the end of QE already fully priced in global assets? Yes and no. Given the pace at which the US unemployment rate has been declining, no one really believes that the Fed’s asset purchase programme will extend too far beyond mid-2014. However, whether the tapering is front loaded or smoothed over the next 9 months will matter for capital flows in and out of EM assets. Much of the market believes that the Fed will begin with a $15 billion tapering in asset purchases; $10 billion in Treasuries and $5 billion in mortgaged-backed securities. Given that the Fed’s tapering announcement severely disrupted global markets in May, one doesn’t expect it to shock the market again. If anything, the Fed could start off with a smaller tapering of $10 billion. In that case, EM assets could benefit but only modestly as it would still mean that QE would be over by mid-2014. What would rally EM assets is prolonging QE significantly beyond mid-2014. This is unlikely. The underlying concern prompting the tapering was that risk was being severely underpriced because of QE. Nothing in the US data flow so far suggests that there is a need to subsidise risk any longer.

Related to the tapering is the Fed’s forward guidance for interest rates in 2016 and whether it changes its communications about the

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