Tapering off

When US interest rates fell to zero,or hit the “zero lower bound”,as economic jargon puts it,the Fed found new ways of easing monetary policy. Earlier,FOMC meetings would simply decide on whether or not to change interest rates,after reviewing inflation and employment in the US economy. But once interest rates were already at zero,and unemployment was high and inflation lower than the 2 per cent level,the question was how to further loosen monetary policy to help push economic activity when the instrument of interest rates was no longer available to the Fed. In this environment,the Fed,led by Bernanke,took the controversial decision of quantitative easing,or buying US treasuries,to increase the supply of money in the system. This was not a tried and tested instrument like interest rates,and its effectiveness as well as its side effects have caused much concern. The policy appears to have succeeded in pushing the US economy out of recession. There was also a lot of volatility in markets. India,for example,saw pressures on the rupee to appreciate and depreciate sharply during this period.

The news of the winding down of the Fed’s QE programme has led to another round of return of capital to the US as the treasury will not be expected to yield a higher interest rate as rates in the US go up. Since that is considered the least risky asset in the portfolio a global investor,the rush to buy dollar assets translates into investors moving away from those in the emerging economies. There is very little that the Indian authorities can or should do in this situation other than warn people to expect high volatility. This is a global phenomenon much beyond the scope of the RBI. The next few months,till the Fed actually winds down QE,are expected to remain volatile. We need to be prepared for a global flow of capital to the US and a strengthening of the US dollar.