Feeding the Economy the Fed Way

By Anahat Danewalia

When Ben Bernanke suggested ‘tapering’ the Fed Policy of Monetary Quantitative Easing three months ago, Markets all over the world frenzied. Stocks fell, Currencies crashed and economies cowered in fear awaiting the impending doom, to be announced on September 18, 2013. Come the day and the same markets are again in a tizzy, celebrating their survival. Economic worries took a back seat as a bull fury seized global markets after US Federal Reserve decided to hold back its tapering plans for a later date. Indian investors joined the party and bought shares as if there was no tomorrow, pushing the benchmark indices nearer record highs. BSE’s Nifty led the rally. However, it is a fool’s paradise, for the doom is still looming in the near horizon. It has only been stalled, temporarily.

After the 2008 crash of the Lehmann Brothers and the subsequent succumb of America to the Great Recession/ Sub-Mortgage Crisis, The Federal Reserve or Fed had adopted the unconventional monetary instruments of asset purchase and forward guidance to guide market expectations and herald monetary recovery. While the Fed has over the last 5 years, pumped about $2.8 trillion into the financial system through targeted asset/bond buying, it hasn’t really been that successful. Bank loans and leases have grown only 4%-marking the weakest recovery since 1960. Excess Reserves deposited (i.e. reserves apart from the Required Reserves) have mushroomed from less than $2 billion before crisis to nearly $2.3 trillion today. In essence, roughly 2/3rds of the money the Fed pumped out never left the building. Why did this happen?

Multiple players, multiple reasons. The primary basis of any successful currency or monetary system is faith. And American faith in its system is progressively declining. Inflation is well below the Fed’s target, unemployment remains high, and there is no certainty in Government policies e.g.: Syria or even the next Fed chief-both critical issues- and the recovery is faltering. Hence the ordinary households are becoming more and more risk averse about future economic growth while the big players choose safer options such as bond markets to gather funds.

For the Fed to maintain trust of the people it was essential for it to stick to its announced policy of taking data determined policy decisions. And the data admittedly showed a much grimmer scenario than previously anticipated. The Fed wants solid proof of economic growth before making any changes. The consensus on Wall Street is that the FOMC would elect to taper its monthly bond buys by $10-15 billion from the current $85 billion pace. Hence Ben Bernanke’s decision to keep stimulus intact at the current pace sent global stocks and gold surging, while interest rates collapsed and the dollar weakened to a seven-month low. The Monetary queasing shall continue for another three months. So what does this imply?

If the Fed intends to ‘taper’ its policy, which it clearly should to prevent setting off any kind of future asset bubble (like the subprime mortgage crisis), it is essential to implement changes. However, as is evident from the last 3 months, even the idea of monetary tapering on the Fed’s part would lead to severe liquidity tightening, discouraging any tapering. And the vicious cycle would go on. Is that reason enough for us to drop our guns?

No. The winter is coming and this time we have to be more prepared to deal with it. America is notoriously selfish and has unwittingly blessed us with a 3 month window. To prevent another crash, at the moment, ensuring a bullet proof economy is of critical importance. Right now, The RBI has 2 options: First, let the currency appreciate, say from the current 62 to 54. India’s projected subsidy burden for the fiscal year 2013 stands at a crippling Rs. 1.7-1.9 trillion (courtesy Moody’s). Hence letting the currency appreciate and consequently bring down inflation and lower subsidy burden as crude oil becomes cheaper seems the logical approach. This will also lower the large foreign debt burden of Indian corporations and boost consumer morale in general.

However, the Second, and more popular school of thought advocates fervent buying of dollars to arrest currency appreciation at a reasonable level and build Forex Reserves instead. As of now, India has the lowest Forex Reserves amongst its BRIC contemporaries at a meagre $274.8 billion. High reserves will give the central bank means to intervene in the market in case of high volatility and also check speculation. An arrested Exchange rate at 62-63 will cushion the fall when it comes. A stable exchange rate will also be more favorable for trade as it will encourage long term contracts. This will boost exports and FIIs and help reduce CAD. The recent Tata-Singapore Airlines venture is testimony of investor faith in India’s growth story. We must use and boost this faith to the best of our advantage.

Ultimately the Fed will taper its monetary policy and growth is the only protection we have against an economic crash. Currently, the dollar has fallen against major currencies and the rupee has some room to breathe. What marks a successful economy from a smart one is its ability to recognize and more importantly, extract opportunities in the most fruitful way. All eyes are on RBI’s new Governor Raghuram Rajan and his new Monetary Policy which will hopefully serve India a much needed Elixir. Cheers!