Fed tapering can help rein in inflation

Over the last six months talk of Fed tapering has created volatility in the global financial markets.

The first part of the tapering talk appeared to be an attempt to shake the bond market out of a euphoric state with the US 10-year bond yield at 1.25-1.5 per cent. It is also clear that the long-term bull market in bonds is now more or less at an end.

However, given low inflationary pressures and high unemployment in most developed economies, the probability of very high yields in such a situation is low.

The initial taper talk was useful in preparing emerging market economies for an eventual tapering

The sell-off in emerging market currencies made these governments take steps to control their current account deficits.

This has been specifically beneficial to India where the fall in the currency has resulted in an up-tick in exports and steps on curbing gold imports have reduced imports significantly.

The tapering of quantitative easing measures by the US Fed could have taken place under two circumstances.

Let’s look at both the circumstances.

Fed QE created inflation and asset bubbles: This was the most feared factor. The magnitude of the quantitative easing by the US Federal reserve had created a fear of asset bubbles and runaway inflation.

Although the initial part of money printing by the Fed did create an upward swing in commodity prices and gold due to fears of inflation, actual inflation in most of the developed economies undertaking these measures has remained below target.

The latest CPI data out of the US and euro zone indicate concerns more related to deflation rather than inflation.

This has actually pushed the ECB to cut its policy rates to 0.25 per cent, down from the already record low rate of 0.5 per cent.

The bubble that had actually formed was in the bond market which was also a risk-aversion play.

Commodity prices also have stagnated and in most cases moved down over the last two years as actual demand has remained weak and commodity hedge funds could not drive prices up continuously in the absence of actual physical demand.

Gold prices have crashed nearly 40 per cent from their peak levels and are looking to correct even more as the concerns have moved away from inflation globally.

Although some people argue that the equity markets are in a bubble phase, the current valuations as well as investor psychology of caution does not actually indicate a bubble phase.

Revival of growth on a sustainable basis: This is the reason why investors should not fear taper.

Continuous money printing at the scale at which the US Fed had done was clearly not sustainable or desirable. The US economy has started showing clear signs of sustainable recovery with jobless claims trending down and job creation picking up.

The housing sector has revived strongly and most measures of manufacturing and services growth have been continuously improving.

Tapering is now going to take place due to a revival in economic growth, which was its main purpose in any case.

However, persistently high jobless rate and low inflation will keep policy rates low for a prolonged period of time and this will keep money cheap, too.

Given the quantity of money that has already been printed by the US Fed, Bank of England and Bank of Japan, liquidity will remain strong in the global economy for a prolonged period of time.

Moreover, the Fed is going to taper and still generate more liquidity over the next 18 months.

It is also true that prices of some commodities are still elevated due to excess liquidity in the system and as tapering takes place, even as economic growth picks up, we should see commodity prices remaining subdued.

In the Indian context a 10 per cent decline in just two commodities — gold and crude —- would reduce the import bill by $20 billion, which is equivalent to the total FII inflows in a year.

Therefore, from a pure economic growth perspective, we would rather have lower commodity prices than some incremental liquidity flows.

Tapering is not only a necessity for reducing long-term inflationary pressures but it is also important from a macro-economic standpoint as the US Fed’s balance sheet is becoming unsustainably huge.

As inflation falls and the economy gets back on a recovery path, money will come into the country in any case if investors find value in Indian assets.

In 2007, the US 10-year bond yields were in the range of 4.8-5.2 per cent but that still did not stop flows into emerging markets. 

One can argue that there has been deleveraging and risk moderation after that; however, huge liquidity has also been generated along with short-term rates in most developed economies being in the range of 0-0.5 per cent.

In conclusion Fed tapering will reflect confidence on the part of the US Fed on the sustainability of economic growth and will be a long-term positive rather than a negative.

It will reduce long-term inflationary pressures on EMs and will aid higher economic growth.

(The author is a business consultant)

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