Any country basically has 2
policies one being the monetary policy which regulates the money supply in the
country and the other one being fiscal policy which regulates the money the
government earns and spends. A country to be seen as attractive for the purpose
of investment, fundamentals of the economy should be strong and have capacity
to generate good returns for the risk taken. Broadly key factors that will be
looked for when investing in a country will be interest rates, inflation & growth
prospective which is influenced by factors like industrial production, currency
stability, unemployment situation in the economy, inflation etc.. I am trying
here to analyze more about the monetary policy, its effectiveness in taming
inflation and spurring growth with reference to Fed rates, QE program and Fed
tapering.
After the 2008 financial crisis,
US started the process of Quantitative Easing (QE) to combat the subprime
crisis that it went through. US economy had halted and there was no growth and
unemployment level was increasing. To spur the growth, production has to
increase which would directly reduce the unemployment. For production to rise,
more money was needed and even though the fed rates were close to 0% it failed
to give the required stimulus and therefore this QE (Bond buying program), which
is the last resort to revive the economy on failure of monetary policy, was
initiated. It infuses money to the economy lowering the interest rates as well
as the exchange rate of dollar which would make US investments attractive which
would further lead to inflow of more capital. Its bond buying program of $85billion
a month was reduced to $75 billion in June 2013 but again on the backdrop of
lagging growth it revived its program within 2 months and then decided to phase
out the program by end 2014. After that the size of repurchase has been
reducing and it’s currently $25 billion a month. This phase out of reducing the
size of bond buying is termed Fed tapering.
Fed clarified it would stop this
QE program once the targets are met i.e. unemployment below 6.5%, inflation in
the range 2.5% to 3% and GDP growth rate of 2% to 3%. And now the numbers are
close to target, and tapering would stop by next month. As a result interest
rates are likely to go up as the artificial demand infused by QE is taken out
from the market. And if the rates increase bond markets will be hugely impacted
as it means lower price of the bonds at least on paper. As soon as the rates in
US rises, capital starts moving out of emerging countries's bond markets and flows into US debt market.
And as an effect the currency of that country depreciates against dollar and if it is an import
driven country like India then it will start building current account deficit.
So this way actions of US creates chain reaction in other emerging economies.
But as per recent statement by our RBI governor Raguram Rajan, India is better
prepared to face the fed rate increase as the chances of capital outflow are
less due to better growth prospects here in India and another line of defense
for India being the plenty of forex reserves which it has built over the past
year which is close to $327 billion.
There has been mixed opinion regarding
rate hikes with one group telling numbers are short term and if rates are
raised US may again fall out growth track and another opposite view supporting
rate hikes. Nobody is sure when Fed will start raising the rates and everyone
is speculating. But what we can be glad about is the growth path that India is treading
in the Modi’s reins and the preparedness or cushion India has developed to face
the Uncle Sam’s sneeze if any!
