Taper Tantrums | Much ado about nothing

For past few months, markets and economics experts of every persuasion have raised the bogeyman of the United States Federal Reserve tapering its assets buying programme and its consequent impact on the markets. The markets have thus seen intermittent bouts of volatility whenever any official of the US Fed or a reputable expert speaks or writes about this change.

The past few days have been no different. Much has been made of what Fed Chair Jerome Powell said at the Jackson Hole Conference in the last week of August. As usual, experts conducted a post-mortem of the speech to find mentions of the words and terms which they can use to market their views in the garb of the Fed’s hints.

For the record, Powell did not say or hint anything at Jackson Hole that had not been said at previous meetings of the Fed Open Market Committee, congressional testimonies and various public speeches. Contrary to the general belief, Jackson Hole is an irrelevant event for financial markets (just like the World Economic Forum at Davos), but that is a topic for another day.

Back to taper tantrum, it is important to understand the implications of the Fed’s assets buying programme.

History Serves As A Guide

To recap: the Fed started its asset purchase programme after the Great Financial Crisis in November 2008. It bought about $1.725 trillion worth of treasuries, agency debt and mortgage-backed securities. It also decided to reinvest the principal amount received on maturity of the securities purchased under the programme. Two more such rounds of quantitative easing (QE) followed in November 2010 and September 2013.

Overall, close to $4 trillion were added to bank reserves during 2008-2014 under the three rounds of QE. Besides, the Fed also implemented Operation Twist under which it managed to extend maturity of over $660 billion US government securities.

The Fed decided to normalise monetary policy in December 2015, but the actual process started only in October 2017. Even then, the Fed only decreased the reinvestment of securities that had matured.

In other words, the tapering of the first three rounds of QE did not entail any sale of securities by the Fed. It just implied that the Fed will not reinvest the amount received in maturity of the securities purchased under the programme. The maturities may happen over a period of up to 25 years.

Consequently, the assets on the Fed’s balance sheet decreased from a peak of $4.5 trillion in the winter of 2014 to $3.8 trillion in the summer of 2019.

Then, as COVID-19 struck, the US central bank started its latest round of QE. Now, its balance sheet has ballooned to over $8 trillion. Presently, the Fed is buying $120 billion worth of securities every month from the market.

Takeaways From Previous Tapers

The key takeaways from this historical review are:

One, tapering does not mean immediate sale of securities held by the Fed. Two, if monthly purchases are decreased by $20 billion, it would still mean that the Fed will still be adding $300 billion more to its balance sheet in the next six months. Three, the Fed’s balance sheet had started to increase in November 2019, even before the pandemic. It can restore its QE programme like in 2020 should the need arise.

The US Fed is not the only central bank which is running a QE programme. So are the European Central bank, the Bank of England, and the Bank of Japan.

It is pertinent to note that QE is a win-win for the Fed and the US economy. The cost of funds for the Fed is zero. So when Fed buys interest bearing securities from the market and infuses more liquidity in the system, it is able to earn a substantial interest income, the interest rates in the economy are pegged lower, the government gets more dividend which helps reduce the fiscal deficit. Not only does the additional liquidity help the financial system stabilise, it also keeps the US dollar from strengthening and helps the traded account of the US.

There is no reason to believe that QE will be completely terminated without significant improvement in the US economy or an even more attractive alternative to QE emerging. Unlike fiscal easing programmes (by way of tax cuts or subsidies) QE does not necessarily result in higher inflation. Inflation actually came down during QE2 and QE3.

Moreover, the argument that tapering will suck out liquidity from the system does not appear to be fully supported. From 2008 to 2014 almost every penny of QE was getting accumulated in banks’ excess reserves (liquidity with banks that can be given as loan). It was only in 2016 (after taper tantrum started) that banks started to grow their loan books by running down reserves. The excess reserves have again increased sharply in 2021 to an all-time high of over $4 trillion.

What Should Indian Investors Do?

Insofar as India is concerned, there is little evidence to highlight any strong correlation between QE and foreign flows, market performance and economic growth.

In the past 20 months, the US Fed has done over $4 trillion in QE. However, the Indian secondary markets have received a paltry $9.7 billion in net FPI inflows. The net FPI inflows since 2010 have been less than $35bn against a QE amount of $8.3 trillion. Five out of the past 12 years have witnessed negative FPI inflows. Nifty returns have shown very poor correlation to net FPI flows in a particular year; even though on a day-to-day basis, a stronger correlation might exist.

Besides, India’s external position is much stronger as compared to the 2013-16 taper tantrum period. The present situation of the current account balance, short term foreign currency debt and forex cover is substantially better than the 2013-2016 position.

Therefore, the common Indian investor need not do anything at all when the Fed actually announces tapering.

The QE of the last decade has not played any direct role in the construction and performance of their respective investment portfolios. They must also keep faith in the collective wisdom gained by of the central bankers of the world since the global financial crisis; and believe that they would not do nothing to harm the still fragile global economy.

Vijay Kumar Gaba is Director, Equal India Foundation.

Views are personal and do not represent the stand of this publication.