Taper home stretch

Global financial markets had been awaiting a signal from the US Federal Reserve for long now and the Federal Open Markets Committee (FOMC) did not disappoint. The Fed maintained status quo on policy rate and assured that it will continue its bond purchases but it was the statement by Chairman Jerome Powell that discussions will commence soon on tapering bond purchases that was the highlight of the latest FOMC meeting. The statement is seen as preparing the markets for the imminent taper of bond purchases that now amount to $120 billion a month. The Fed revised median real GDP projections for 2021 upwards to 7 per cent while PCE (personal consumption expenditure) inflation for this calendar, at 3.4 per cent, is 100 basis points higher than what was projected in March. Given the robust growth led by household spending, strong demand in housing and a steady improvement in business investment, it is not surprising that the median projections for the Fed funds rate now indicate at least a 50 basis points rise in policy rates in 2023.

With the ultra-low interest rate in the US as well as the liquidity pumped in by the bond purchases fuelling the current rally in global asset prices, it’s not surprising that there was turmoil in financial markets following the FOMC statement. The dollar rallied strongly sending other currencies, including the rupee, sharply lower and global bond yields too moved higher. With the Fed going on a money printing spree since last year, its balance sheet as well as the US government debt as per cent of GDP has increased to record levels. Many of the Federal Reserve Presidents and other policymakers have been urging a review of the quantitative easing policy, given the robust recovery in the economy. While Chairman Powell continues to hold that conditions in the labour market are not favourable and weaker sections need monetary support, it is clear that serious discussion on tapering the stimulus is set to begin. Financial markets, especially in emerging economies will have to brace themselves to face the volatility that such an announcement can usher.

The Fed’s stance towards inflation will also be under close scrutiny in the days to come. Despite PCE inflation featuring well above its target rate of 2 per cent, the central bank continues to maintain that the spike is transitory, holding that supply bottlenecks in some sectors which are unable to meet the surging demand, has led to the increase in inflation. It is to be seen whether the Fed is right in assuming that shortages could ease with increase in labour force participation and higher production. Indian policymakers may be hoping that the Fed’s prognosis on inflation proves right and international commodity prices cool down after a few months as supply increases. But, if global demand continues to outpace supply, both the Fed and the RBI may have no choice but to take appropriate monetary action to address inflation.

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