Context:
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Headline inflation in the US has reached 6.8%, the highest value in 40 years.
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In this context, if the US Federal Reserve resort to monetary tightening policy (Fed Tapering) to control inflation, it will have important consequences for the world economy.
What is easy monetary policy and why it is adopted?
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When central bank keeps interest rates low it is called easy monetary policy. Whatever interest rates central bank (here Fed) decides is base rate of lending of loans in that country. As this is the rate at which bank can borrow from central bank.
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Due to low interest rates by central banks, interest rates set by banks for lending to corporate or individual comes down (at least theoretically, banks are not obligated to pass low interest rate but generally due to competition are forced to do that). By more lending the investment in economy goes up which leads to growth. This is rationale behind setting/ cutting interest rate to stimulate economic growth.
What are the components of easy monetary policy?
2 components of soft monetary policy of US
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Almost zero interest rates
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Quantitative Easing – which is being unwounded in stages beginning end 2013. QE has involved massive purchase of bonds by the Fed with newly created money to keep interest rates low.
Impact of US easy monetary policy?
US followed easy monetary policy post 2008 crisis – setting interest rates near zero which was followed by Quantitative easing (buying government bonds held by corporate to increase money supply in economy in turn to stimulate growth). This easy money flooded emerging country like India – leading to increase in stock markets, real estate prices along with investment in real economy.
What is Fed Tapering?
Reversal of easy monetary policy is called Fed Tapering. Government can adopt Fed Tapering due to high growth or high inflation.
What are the implications of Fed tapering? (#diagram cycle)
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Flight of capital from the emerging markets: High interest rates in the US suck capital into the US.
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Value Erosion: In international asset pricing, the cost of capital goes up, and the net present value of Indian equities will decline.
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Financial Scandals will get exposed: Many dubious schemes fall apart, as we saw with the financial scandals in India from 2008 to 2013.
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Autonomy of monetary policy: The retreat of capital will generate currency depreciation. To fight the currency depreciation, high interest rate hikes are required, which is often harmful for the local economy.
Why India is better prepared against US fed taper this time?
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Federal reserve has communicated its intentions a bit early this time. It has provided some time to the economies, to be prepared.
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India is less vulnerable to external vulnerabilities now. It is because Rupee is not overvalued, as was the case in 2013. Also, India’s current account is in surplus and Foreign Currency reserve currently cover nearly 12 months of imports.
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Basic balance of payments (BBOP) is in surplus (BBOP is the sum of current account and net FDI inflows).
What are the causes of concern?
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Current Account trend is changing. Merchandise trade deficit is widening.
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Higher commodity prices such as crude oil, metals, etc., and improvement in domestic demand is increasing India’s import bill.
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Gold imports have surged over the last year, rising to $55 billion in the 12 highest since 2013.
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India’s BBOP is going into deficit from surplus.
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High relative inflation, compared to competitor Asian countries can erode it’s export competitiveness.