Beginning of the end

The six-year-long quantitative easing programme, costing $3 trillion, may have ended, but the Federal Reserve’s task of taking the US economy towards normalcy is far from complete. Stopping the infusion of additional sums into the economy every month is the easy part; the Fed now needs to devise a way of selling treasury and mortgage backed securities — purchased from late 2008 onwards — back to the banks and hedge funds. This is going to be somewhat difficult. At the same time, it is probable that Ben Bernanke prevented the US from slipping into a depression by increasing money supply and pulling interest rates as low as possible in 2008. This action helped the US economy recover, reduced the unemployment rate and caused a modest revival in consumption.

But the unintended consequence of this flush of liquidity was price inflation in assets ranging from equity to real assets; not just in the US, but across the globe. These prices did not adjust as the tapering of the QE began. But once the Fed begins sucking out the liquidity, the financial markets may well witness a slide. With both equity and real estate prices in many markets ruling at record highs, and far above their fundamental worth, a reduction in liquidity has the potential to wreak great damage. The low interest rate in the US has also contributed to pushing financial asset prices higher. The positive tone adopted in the recent FOMC statement implies that the Fed could proceed with its intended interest rate hike next year; this, despite inflation at below its targeted 2 per cent. That the Fed is now choosing to brush aside the consequences of its actions on emerging markets, despite the apprehensions of central bankers, including the Reserve Bank of India governor, denotes that it is now time to prepare for the inevitable adjustments in asset prices.

India is, however, better placed now than it was a year ago to deal with such turbulence. Foreign exchange reserves are at a record high, the currency is stable and the current account deficit is under check. Foreign portfolio flows have also been very strong, at close to $35 billion since the beginning of this year. But the sudden bout of volatility witnessed since the last week of September and the outflow of portfolio funds from the equity market, on growing concerns about the end of QE, reveal a glimpse of vulnerability. A tight vigil needs to be maintained on the external account and the currency to tide over any possible instability. This situation also highlights the need to develop a larger base of domestic investors in the equity and bond markets to counter selling by foreign funds.

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