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 interest policy. The US labour market has improved substantially with employment gains averaging 180,000 per month. Tail risks to growth have abated as the euro area is exiting recession and the US has absorbed most of this year?s 2% of GDP fiscal drag. The rapid rise in long-term interest rates, including mortgage rates, is a concern but US financial conditions remain broadly healthy. Consequently, the Fed is likely to maintain a 2014 forecast of GDP growth above 3% and an unemployment rate fall to below 7%, bringing the economy close to full employment. Under normal circumstances, the Fed would be expected to set policy rates near its 4% estimate of neutral. Such guidance would disrupt the market. So, it is likely that the Fed will signal only a gradual normalisation path with a median rate forecast of about 2.25% for end-2016 with the first rate hike somewhere in 2015.
Here is where market expectations have differed from Fed guidance. There is a strong belief in the market that once tapering is over a rate hike will follow soon. The Fed has tried hard to stop the market from conflating the two by reiterating that the benchmark for considering a rate increase would be if unemployment fell to 6.5% or inflation rose to 2.5%, but that would still not trigger a hike. Thus, to anchor interest rate expectations, the Fed could recalibrate its communications. There are several options. It could lower the unemployment threshold to below 6.5% or qualify it with other indicators such as the labour participation rate, add an inflation lower bound, i.e. the Fed would not let inflation fall below, say, 1.5%, present a consensus or median interest rate forecast of the FOMC, or tie together the exit sequence (stop reinvestments on principal payments, followed by reserve draining, and then the first rate hike) with numerical thresholds. Among these options the only ones that really stand a chance are presenting a median forecast of the interest rate path and adding a lower bound to inflation outlook along with a strong reiteration that tapering is not tightening and that future tapering decisions would be data-dependent in both directions.
What does all this mean for India? Over the last two weeks things have definitely been on the mend. First the new Governor?s policy initiatives and then the passage of several Bills in the last days of the monsoon session of Parliament have helped to give a sense of policy resetting. This has been followed by better trade and IP data. And, as a result, the rupee has appreciated and capital inflows have started to trickle back. The restrictions on gold imports and the fall in non-oil/non-gold imports due to the economic slowdown have reduced the run rate of the current account deficit significantly. Indeed, it is likely that for this year the deficit could be much lower than even the government?s $70 billion estimate. The decision to fund imports of the three public sector oil companies directly through dollar loans by RBI has effectively changed the current account deficit to a modest surplus for this year, of course at the cost of losing about $80 billion in usable current reserves.
Yet there is still palpable investor nervousness about India. Why? Because it is unclear that the recent rupee appreciation has been purely because of better domestic policy. Currencies of other EM countries with current account deficits have actually appreciated much more because of improved global sentiment. How strongly these policies will support the rupee if global sentiment again turns sour is questionable. Taking out oil imports only opens up a temporary breathing space. And it is slowly sinking in that subsidising banks to market more NRI dollar deposits may not yield very much in net new inflows. The only long-term positive support has come from the proposed banking reforms. By itself, it is not sufficient to allay investor fears. Going back over and over again to the same pool of resources?NRIs and global equity funds?has run into limits. The authorities will have to find other sources of sustainable external financing. Longer they postpone this decision, longer will
India remain hostage to the whims of global sentiment.
To be concluded
The author is chief Asia economist, JP Morgan Chase. Views are personal
