In response to the 2007-08 global financial crisis, the US Federal Reserve introduced quantitative easing (QE), which essentially means creating new e-money by buying bonds from the market. Additional money was pumped into the economy to keep financial institutions and the US economy from falling into recession.
The “tapering” or withdrawal of QE first hit the market in 2013 when then Fed Chairman Ben Bernanke spoke about scaling back the QE bond-buying program to normalize monetary policy operations in the world’s largest economy. This sudden announcement of “tapering” by Bernanke resulted in a huge outflow of dollar funds from emerging economies such as India, affecting both the equity markets and the value of the currency against the US dollar.
QE efforts over the years have swelled the Federal Reserve’s balance sheet from less than $ 1 trillion in 2007 to over $ 8 trillion now. The sudden “tapering” of the US Federal Reserve is now feared again as the central bank pumped money into the economy after the pandemic. Let’s understand all of the issues involved.
What is the current position of Fed rates and bond purchases?
The US banknote or short-term interest rate has been in a range of 0 to 0.25 percent, the lowest or near zero, since March last year. The Fed interest rate is the rate at which banks borrow money from the central bank. Just like the RBI’s repo rate, the Fed rate is the benchmark rate that affects lending rates on home, auto, and other loans.
Also read: Tata Motors increases prices for commercial vehicles from October 1st
In addition, the Fed is currently buying bonds worth $ 120 billion a month from banks and financial institutions. By buying bonds from the market in this way, additional money is released into the financial system. The extremely low interest rates and bond purchases encourage the flow of cheap money into emerging markets for short-term gains.
Why is the two-day Open Market Committee (FOMC) meeting on September 21-22 important?
The 12-member FOMC members set the Fed’s interest rates and also manage monetary policy with the aim of supporting long-term growth and jobs. In India, there is the RBI Monetary Policy Committee with half a dozen members that sets interest rates in the country. FOMC members will meet September 21-22 to accept a call for short-term rates and a bond purchase program.
What are the problems before the FOMC?
In terms of short-term interest rates, the Fed is likely to maintain the status quo. In fact, the Fed had previously announced that the first rate hike was expected sometime in 2022. She could advise on bringing the dates forward further, depending on the discussion among the members. The big problem ahead of the FOMC, however, is the pace of the slowdown in monthly bond purchases worth $ 120 billion. The market expects the Fed to curb or slow down monthly bond purchases.
What would happen if FOMC decides to slow down its purchasing?
Any decision to slow the pace of bond buying will have an impact on emerging markets. Loose monetary policy with low interest rates – both in domestic and world markets – has fueled asset prices everywhere. The danger of inflation is already becoming apparent. There are some economies like Brazil and Russia that have started raising their interest rates. In India, too, the RBI has forecast an inflation target of 5.7 percent, which is closer to the upper limit of 6 percent targeted by the RBI.
Any retreat from bond purchases would mark the beginning of the end of the easy monetary policy cycle around the world. This will affect the country’s stock market and the value of the rupee against the US dollar. If the FOMC decides on a very orderly withdrawal or a chronological sequence over a longer period of time, the effects are likely to be less.
Also read: Evergrande China’s Lehman Moment is reminiscent of IL&FS: Uday Kotak