The tinker, the tailor, and the candlestick maker all have been pummelled by the US Fed?s announcement in May that it planned to reduce the pace of liquidity support (QE) to the economy. Everyone knew that this day would come but it was sooner than most had expected. Global markets went into a tizzy, US interest rates jumped up raising the cost of funding which meant that emerging market assets were no longer as profitable, as a result inflows into these markets fell sharply that heightened concerns that economies with a current account deficit would find it very difficult to secure adequate funding, which, in turn, send their currencies into a tailspin. Such is the power of the US Fed. India with the second-largest current account deficit in the world was caught in the cross-hair.
But what exactly did the US Fed say? For more than a year the Fed has been purchasing $85 billion of government- and mortgage-backed securities each month. As a result, $85 billion of cash has been added each month to dollar liquidity. This kept US long dated interest rates low, dollar weak, and helped the US economy recover. This is different from the policy of keeping the Fed funds rate at close to zero. As the US economy began showing signs of recovering and corporates and banks became healthier, the need to continuing adding liquidity apace diminished and so the Fed decided to slow the pace of addition to the liquidity.
This does not mean that the Fed is going to reduce the stock of US dollar liquidity. In fact, it will keep on adding to it. It does not mean that when the quantitative easing (QE) is stopped, and we have no reason to believe that it will any time soon, the total amount of dollar liquidity will be any less than if the pace of QE was continued. To draw an automotive analogy, just because the acceleration has been reduced it does not mean that the car will come to a stop sooner. The car can go on for much farther distance at a reduced pace. In fact, there is nothing to suggest that the Fed won?t end up adding more liquidity to the system by carrying out the QE at a reduced pace for longer than it would have done at the current pace.
So why did the market react so violently? Partly because the inflow of liquidity matters as much as the stock of liquidity. Tapering the bond purchases means that the market will have to pick up a greater amount of US bond issuance. And partly because the market wasn?t really prepared for the tapering to end this quickly. Most market participants had been targeting the end of 2013 or the beginning of 2014 as the start of the tapering. Today, the fear is that it could start as early as September.
What about the zero interest rate policy? The Fed has bent backwards to distinguish the goals of QE (the asset purchase policy) meant to provide ?some near-term momentum? to growth from those of the interest rate policy, which is meant to provide sustenance to the recovery. And that?s why the Fed plans to maintain the zero rate policy till the unemployment rate reaches 6.5% or inflation 2.5%. No such promise has been made about the QE. While job addition has occurred at a reasonable pace in the last few months, as the Fed itself acknowledges, the unemployment rate continues to either ?overstate the health of (the US) labour market? or ?understate the weakness of the labour market.? In other words, bringing down the unemployment rate will be much more difficult because a big factor keeping the rate down has been the fall in labour participation rate as people have just walked away from the market having waited too long to find a job. As the economic recovery gathers traction, these workers will likely come back to the labour market. This will keep the unemployment rate high and the zero interest policy for even longer. But if the unemployment rate is sticky because the participation rate rises then it is a good thing as it will underscore increased confidence and faith in the US economy.
What does all this mean for emerging markets and India? If indeed the tapering starts in September, as presently feared, it could spell another bout of uncertainty in global markets. The reason being that the Fed has not given any hint by how much the monthly asset purchases will be lowered. What will be the pace of this reduction? Will purchases of only government securities be reduced or will the Fed also reduce mortgage backed assets? At present, the expectation is that the Fed will start slowly and only with government assets as the housing market still requires support. But the market could be wrong in either direction.
That said, the world will remain awash with liquidity for a long time to come. So, once the September episode is over, markets should stabilise and the liquidity should once again start searching for yields. For India and other emerging markets the trick is to provide this yield. Higher growth, lower inflation, stronger reforms are the key attractors. So far this year emerging markets have performed badly along all these facets. And they have paid the price for it.
The author is senior Asia economist, JP Morgan Chase. Views are personal
