Tapering to tightening: the countdown starts

Chances are high that the US Federal Reserve is going to raise its policy interest rate first time after the crisis of 2008. Since the crisis, the Federal Reserve is following an easy money policy with abundant liquidity and reduced rate of interest to stimulate the economy. Three Quantitative Easing (QE) phases with the third one a very impactful one were launched by the Federal Reserve.

At the end, now US employment data shows that unemployment rate has came down notably. The Federal Reserve which accumulated bonds over the last seven years has to sell them back. Return to normalcy is inevitable; the time has reached right now.

The Fed can’t get a better signal to inevitable reversal of its monetary policy it had adopted in 2008. Every easy money policy by encouraging banks to lend more and individuals and business to spend more has the risk of aggravate debt. It may similarly bring another crisis by increasing the bad debt with the banking system.

Monetary policy’s history in the last two decade shows that when the Fed raises or lowers the interest rate, it will have huge impact on emerging market economies. What we are seeing now is synchronization of monetary cycles, with the Fed acquiring the position of the central bank of the entire world.

Financial markets and the follow up real economic activities are now highly sensitive to words and actions by the Fed. On May 22, when the Fed announced the possibility of tapering, financial markets across the world reacted violently-shedding many percentage points. Currencies of the emerging world with hard currency scarcity depreciated heavily.  In India, the Rupee has lost almost 18%.

May 2013 was a realization about the impact of a monetary policy action by the world’s largest economies’ central bank on global economy. Central bankers including the Fed learned the lessons and the deeper ‘interconnectedness’ in the global economy.

After that, many EME central banks have requested the central banks of the advanced countries to implement monetary policy on a collaborative manner. That is by understanding the environment of the developing world.

Few words by the Fed have caused tremendous damage on the financial market of the developing countries. Now it is coming into action. But the central banks including the RBI are better prepared now. The situation is well anticipated and central banks have deployed safety mechanisms. In India, the RBI was doing preparatory works including cushioning the debt market.

EMEs that are hit with recession, commodity price fall and those who are too much depended on capital inflows may come under pressure from the Fed action. At the same time, anticipated nature of the Fed move can definitely erase big volatilities. Countries like Turkey, Brazil, Russia, Indonesia etc may be significantly affected by the Fed decision. For India, the Rupee is sitting near to the seventies. Significant withdrawals from the debt and equity market can take Rupee to 70/$. But still economic fundamentals provide a cushion to the financial market.