The shifting landscape of monetary policy in the United States (US) could test vulnerabilities of emerging markets (EMs) such as India in coming months
With economic recovery under its belt, the US Federal Reserve (Fed) is likely to begin the process of ‘normalisation’ of monetary policy, first by tapering its asset purchases. This could have two major global fallouts. One, other central banks would follow suit. Two, it would spell the beginning of a gradual draw-down of ample global liquidity
S&P Global expects the Fed to start tapering by 2021-end, with the Fed Chair indicating as much at the recent Jackson Hole symposium. However, normalisation is expected to be gradual, with a hike in policy rates expected only from 2023
Compared with 2013, India’s external position is much stronger on account of a lower current account deficit (CAD) and larger forex reserves to cover short-term liabilities
Domestic macros, however, remain weak, though recovering. Gross domestic product (GDP) is moving towards pre-pandemic levels, but its pace lags EM peers such as China and Turkey. High inflation and public debt persist, ranking weaker than those of other EMs
The US Fed Chair Jerome Powell’s virtual address at the Jackson Hole symposium last week holds some vital clues on what the Federal Open Market Committee (FOMC) might do when it convenes in September.
During the Covid-19 pandemic, the Fed brought short-term interest rates to near-zero and restarted large-scale bond purchases (of $120 billion each month), referred to as quantitative easing (QE).
QE has the effect of lowering yields, and significantly easing US financial conditions (see chart below).
Normalisation works in the reverse. It would begin with the Fed buying fewer bonds – hence ‘tapering’ – followed by raising of policy rates.
The last leg would be balance sheet reduction or sale of assets purchased. That could extend over years.
Compared with 2013, the Fed is being more cautious in normalisation this time, prioritising economic recovery even as inflation remains above their target. Powell also stated explicitly: though the Fed sees conditions ripe to begin tapering, the move is not intended to carry a signal on hiking policy rates, for which it has different and more stringent tests.
Thus, financial conditions have been unscathed so far.
But if we take a view longer than here and now, many unknowns lurk in the path to normalisation.
Historically, a shift in Fed’s stance has shaken global risk sentiments of investors and caused capital outflows from EMs. In this Insight, we take a close look at what a potential tightening in global financial conditions as an outcome of Fed moves could mean for India.
