Why you need to worry about the Fed

In a highly anticipated meeting that concluded on December 18, the US Federal Reserve voted to slightly taper its stimulative bond-buying programme to $75 billion a month from the $85 billion a month policy that it adopted in September 2012.

By printing money to buy up US treasury bonds and mortgage backed securities, the goal was to pump cash to the banking sector — cash that, the Fed hoped, would be lent to consumers and businesses to motivate economic growth. By the time this tapered programme finally ends, the Fed may well have accumulated nearly $5 trillion in bond assets. Never in the history of any reserve bank has so much free money been printed.

The trick worked. US data released last week indicates that the US economy is strong. The job numbers are improving, GDP growth was revised upwards, the US stock market is at record highs, manufacturing continues to show strength, US oil production is on the rise and exports are higher.

But there will come a huge cost, sooner rather than later. All this money from thin air has to be ultimately recovered and returned to the Fed so that its balance-sheet will look normal again. The only sane route for the Fed is to gradually shrink its bond portfolio as the bonds mature, in a soft landing approach that creates no surprises.

Imagine what would happen if the Fed tries to sell some of the bonds in its portfolio before they mature and demand that its free cash be returned to it. The action will likely crash markets worldwide as it will be seen as a move to contract the supply of dollars in the economy.

Global impact Fed actions have an oversize impact not just in the US but around the world. The supply and demand equation of US dollars still drives international trade, invoicing and settlement. Most commodities worldwide (oil, gas, soybean, wheat) are priced, sold and bought in US dollars. Sixty per cent of the dollar’s circulation is outside the US. According to BIS, the dollar was on one side of 87 per cent of all international trades in 2013; the rupee was on one side of just 1 per cent of all international trades.

With all the free money during the last five years, US banks and hedge funds chased Indian markets in the pursuit of short-term profits. A new report from the McKinsey Global Institute estimates that purchases of emerging-market bonds by foreign investors went from $92 billion in 2007 to $264 billion in 2012 — a 280 per cent increase! Growth in India soared, the rupee strengthened as foreign direct investment arrived in droves and asset prices grew even higher.

Responsible or beholden? But the mere whisper of a taper by the Fed, in June 2013, caused the opposite effect. Foreign institutions and hedge funds began to pull dollars away from India fearing an end to the free money spigot operated by the Fed.

The rupee tanked to record lows in September and while it has recovered somewhat thanks to improving trade deficit numbers and sensible RBI policies, there is no question that the Fed’s taper trial balloons have had a lasting negative impact on the rupee.

The important privilege (and indeed global responsibility) of deciding the supply (and hence, value) of the dollar belongs to the seven unelected governors of the Fed.

Given the pre-eminence of the dollar on the world stage, is the Fed adequately serving the global economy by preserving the dollar’s value? Or is it too beholden to meeting the interests of the US?

The surprising answer lies in a largely unknown US-centric mandate that binds the Fed. The US Congress, in 1977, required the Fed to do whatever it could to keep US unemployment low.

This dual mandate — of maintaining the dollar’s value (i.e., managing inflation) and managing US unemployment — resulted in the Fed’s unprecedented QE programme.

From an emerging markets perspective, the Fed’s performance has been terrible. It’s decisions have created economic havoc for countries around the world — nations which have no say in the Fed’s policies at all. Consider commodity markets. By printing more dollars unceremoniously the Fed has effectively lowered the dollar’s value.

When the dollar is lower, commodity producers will want more dollars for the same commodity.

This is one reason the price of oil has stayed around $100 a barrel although energy demand actually fell during the global recession and supplies have been steady, and even increasing.

Crude oil counts High oil prices strain India’s trade deficit because India is such a massive importer of oil and oil products. The University of Pennsylvania’s Wharton School ran a story recently which concluded that “the weakness or strength of the Indian rupee will continue to be largely determined by the level and costs of the country’s crude oil imports”.

The fall of the rupee has been a key factor in driving up overall Indian inflation.

Yes, the Indian export sector has surged but a large economy such as India needs to become competitive on its own, not because of a falling currency.

There are winners as well.

The Wall Street Journal ’s Asia Business section on August 20, 2013, quoted Sandeep Muthangi, an analyst with Mumbai-based brokerage firm IIFL Capital: “A 1 per cent decline in the value of rupee against the dollar may add to the profits of such companies by nearly 2.5 per cent.”

No wonder our IT industry titans never complain about a falling rupee.

An Indian student who obtained a loan from his local bank to pursue US graduate education in the fall of 2011, found a US job, and has begun repaying his loans now should be all smiles as well. Because there’s nothing like repaying loans at a 40 per cent discount.

So the next time you go to the pump to fill up your vehicle or invest in that nice apartment, look westwards and pray to the Fed. It has a lot more control on you than you think.

(The author is Managing Director of education consultancy Rao Advisors LLC.)