Taper tremors

Jan 29 2014, 20:48 IST
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SummaryThe ‘taper tantrum’ that followed the announcement of tapering in May 2013 suggests that the normalisation of rich countries’ unconventional monetary policies may lead to capital outflows and currency depreciations in emerging markets

Quantitative easing (QE), which started in 2008, swelled the Federal Reserve’s balance sheet to an unprecedented $3.4 trillion. In May 2013, the Fed announced that it would evaluate the possibility of a reversal of its unconventional monetary policies—QE in particular.

The event, which has come to be known as ‘tapering’, prompted a sharp, negative response from financial markets (the so-called ‘taper tantrum’): US long rates rose by almost one percentage point between late May and August, and the concomitant rebalancing of global portfolios away from emerging-market assets resulted in capital outflows and currency depreciations in several large emerging-market countries. Brazil, India, Indonesia, South Africa and Turkey were particularly affected.

Surprised by the strength of the market response—and further bolstered by somewhat tepid labour market data—the Fed held back on actual tapering action over the course of the rest of the year. In the interim, it pressed on with conditioning market expectations for an eventual slowdown in large-scale asset purchases. The long-awaited taper eventually began in early January 2014.

How will Fed policy normalisation unfold in the years ahead?

This question is crucial for developing economies, since they have benefited substantially from increased inflows over the period in which QE policies have been in place—total gross inflows as a share of GDP appear to have picked up over the course of all three QE episodes (figure 1). The risk of reversals in such inflows is therefore a genuine concern as the Fed embarks on its normalisation plans.

Much work has been done on identifying factors associated with financial inflows. Our recent research builds on this to address the effects of monetary policy normalisation on financial flows to developing countries (World Bank 2014). Our approach relies on a suite of three models for financial flows and crisis that incorporate elements designed to capture the effects of QE unwinding.

The first model that we use to establish our baseline scenario is a dynamic panel model. This model allows for the tremendous cross-country heterogeneity in gross financial flows, while also accounting for the effects accruing to global and domestic factors that can potentially affect inflows. These include real (growth and growth expectations) and financial (interest rates, interest rate differentials, and the VIX index) conditions, alongside institutional drivers (such as country credit ratings). Crucially, in addition to (time-invariant) country fixed effects, we also include a series of indicator variables that are designed to capture whether episodes of QE may have had

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