The course of policy normalization
Macroeconomic data of the past few months from G7 economies is increasingly showing evidence of rising growth momentum. The annual rate of real gross domestic product (GDP) growth is running above the long-term (15-year) average in the US, eurozone, UK, Japan and Canada. The leading business confidence surveys and the Purchasing Managers Index (PMI) are also pointing at an upturn in growth. The only missing piece in an otherwise brighter picture is the soft inflation which has been fairly acknowledged in recent statements by major central banks, including the US Fed and the European Central Bank (ECB). However, their rhetoric suggests that it will take some time before inflation converges towards their target. This reflationary environment and consequent hawkish shift in major central banks’ communication, coincident with improvement in their respective domestic and exogenous risk environment, has brought monetary policy normalization into focus.
In the aftermath of the global financial crisis in 2008 and the bond market crises in the European Union in 2012, the major four central banks (US Fed, ECB, Bank of England and Bank of Japan) had cumulatively injected around $9 trillion into the global economy.
The US Fed started normalizing its policy rates in December 2015 and has laid down the broad plan for reduction in its balance sheet size in the form of quantitative easing (QE) retreat. Similarly, the ECB has recently turned slightly hawkish in its outlook and markets expect it to scale down its asset purchases from the current pace of €60 billion per month to progressively end them by next year.
Not surprisingly, a large part of this liquidity has found harbour in financial assets, including emerging markets (EMs). In this context, the upcoming QE retreat could have a potential and scale that has not been seen before in the history of the global economy and is hence an unknown that the market has to grapple with.
The current balance sheet size of the US Fed stands at approximately $4.4 trillion, roughly 25% of the US gross domestic product (GDP). In its July meeting, the US Fed had stated that it “expects to begin implementing its balance sheet normalization programme relatively soon”. The financial markets expect the official announcement to come in the next Federal open market committee meeting scheduled for next month. Given that there is more demand now for currency in circulation and reserves in the banks, markets estimate that the Fed will bring down the size of its balance sheet to 15% of GDP by unwinding approximately $1.5 trillion. This is likely to be achieved progressively over the next four years as the Fed allows outstanding bonds to mature as and when due and doesn’t resort to direct sales of bonds in the open market.
The impact of QE retreat on global markets and the resultant withdrawal of global liquidity will be measured primarily through the impact on the US treasury and the US dollar. The US Fed balance sheet reduction is incrementally positive for the dollar due to the withdrawal of liquidity from the system. However, given the unfolding scenario of reduced monetary policy divergence by other central banks with the Fed, any sharp appreciation of the dollar is unlikely. Similarly, the Bank of Japan’s continuation of QE will mean that global liquidity can be partially supported. Structural dollar strength will return only if the US economy again starts outperforming other markets, both in terms of growth and inflation.
The ongoing dollar weakness has created an environment where the sentiment for high-yielding EM assets remains positive. It is also evident that reductions in some measures of vulnerability through low inflation, positive/narrow current account balances and enhanced foreign exchange reserves have infused a sense of market complacency regarding EM prospects. However, a rise in term premium and absolute yield in developed economies reduces the scope for monetary easing in the EM economies and incremental capital flows. EM assets, including fixed income, have been the biggest beneficiaries of the QE regime due to low yields in developed economies. Therefore, rising yields there would be a cause for worry in the initial stage of tapering. However, given that the real rates in EMs are still on the higher side and macroeconomic variables in the aggregate are benign, the quantum of outflow will depend on the relative macroeconomic performance of the individual country.
Further, robust foreign exchange reserves in EM would ensure a contained depreciation pressure on currencies in the aggregate and India in particular. It might, however, be noted that EM assets tend to get classified as a group and hence even though countries like India stand out with respect to the macroeconomic factors, the impact of capital outflows (or reduction in capital inflows) will nevertheless be felt.
In aggregate, low inflation, benign growth impulses, strengthening labour markets and easy financial market conditions provide a “Goldilocks scenario” (moderate growth with low inflation) where developed markets’ central banks seem eager to fine-tune their ultra-loose monetary policies at the least disruptive cost. It appears that currently markets have absorbed the taper signals in a non-disruptive manner. However, truer tests will come when both the US Fed and the ECB announce the start dates of the QE retreat. We also expect that the stance of US monetary policy will not be determined by balance sheet normalization in isolation, but by its combination with the path for the Fed funds rate. If the adverse effect of the balance sheet run down on financial markets is larger than expected, it could quickly be offset by a more dovish path for short-term interest rates.
B. Prasanna is group executive and head of the global markets group at ICICI Bank.
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