The latest World Economic Outlook update by the International Monetary Fund (IMF)—while maintaining the previous global growth forecast—has lowered its 2017 and 2018 growth projections for the US. This is largely because fiscal policy is now expected to be less expansionary than was previously assumed. The IMF now expects the US to grow at 2.1% in the current year, compared with the earlier projection of 2.3%. Analysts and market participants are coming to the realization that it will perhaps not be easy for the Donald Trump administration to pursue policies of its choice.

All this is likely to seep into the deliberation of the rate-setting committee of the US Federal Reserve which will meet on 25-26 July. Although the Fed did not alter its policy path in anticipation of an expansionary fiscal policy, the diminishing possibility of fiscal support could have an impact on economic activity and inflation. After the central bank raised rates in its June meeting and outlined its plan to shrink its $4.5 trillion balance sheet, markets are not expecting it to raise rates this time around. According to the official projection, the Fed expects to raise rates one more time this year, followed by three hikes next year.

However, financial markets are of the view that policy normalization will be much more gradual. Consequently, stock markets continue to trade at levels close to all-time highs, volatility has virtually disappeared, and the 10-year government bond yield has drifted below the level seen in the beginning of the year. The reason for this is below-target inflation. In fact, Fed chairperson Janet Yellen recently told US lawmakers that the central bank is ready to adjust its policies if inflation persistently undershoots the target. However, the Fed is not the only central bank that continues struggle with below-target inflation. The European Central Bank has decided to postpone the discussion on reducing the quantum of asset purchase because of lower inflation and the Bank of Japan has lowered its inflation forecast.

As inflation continues to undershoot the target, it appears that financial conditions will remain reasonably accommodative in the foreseeable future. It remains to be seen when the Fed will decide to start reducing the size of its balance sheet as it could have an impact on capital flows, which could affect financial conditions in the global market. In the past, a number of countries were concerned about the spillover impact of quantitative easing in terms of higher capital flows and appreciation in the exchange rate. Shrinking of the balance sheet can now have an opposite effect. Lael Brainard, member of the board of governors of the Federal Reserve, in a recent speech touched upon this issue and noted: “...while the international spillovers of conventional and unconventional monetary policy may operate broadly similarly, the relative magnitude of the different channels may be sufficiently different that, on net, the two policy strategies have distinct effects." Raising policy rates would have a greater impact on exchange rate compared with monetary tightening achieved through a reduction in balance sheet owing to the higher sensitivity of short-term rates to the exchange rate.

In terms of effects on financial conditions, economists believe that a gradual reduction in the Fed’s balance sheet will have a relatively moderate impact. For instance, a survey result published by The Wall Street Journal in May showed that more than half of the participants expect that “letting maturing assets run off the central bank’s balance sheet would raise the yield on 10-year Treasury notes by 0.2 percentage point or less". Similarly, a note published by researchers at the Federal Reserve Bank of Kansas City found that a $675 billion reduction in the Fed’s balance sheet over a period of two years would be equivalent to a 25 basis point rate hike.

One way of looking at all this is that a gradual reduction in the Fed’s balance sheet will have a limited impact on capital flows and exchange rate movement. This is likely to provide policy space to central banks in other parts of the world to focus on their domestic economic situations. However, this does not mean that policy and financial market risks are completely off the table. A pick-up in inflation, probably because of a tightening labour market in the US, could change market expectations very quickly. Rich valuations could end up magnifying market correction and affect investor confidence and growth.

What does it mean for India? At the macro level, India is in a strong position and should be able to handle a gradual normalization of monetary policy in the US. However, investors in the stock market need to be more careful as higher valuations may trigger a sharper correction if global risk appetite wanes.

How will the shrinking of the Fed balance sheet affect global markets? Tell us at