‘Tapering’ is not a word you come across often. But these days, all the talk in financial markets is about when the US Federal Reserve will start tapering. So, can taper tantrum 2.0 be on its way? How will it impact you? Before that, let us understand what Tapering means in the financial world.
You see, when the government wants to boost the economy - Moratorium on interest payments, EMIs, etc. are temporarily being provided. Similarly, when an economy is under stress and faces liquidity crunch, the central banks step in and buy bonds to induce liquidity into the economy. Basically, it increases money supply in the economy by buying out bonds in exchange for cash.
This is called ‘Quantitative Easing’ (QE). But, as they say in Wall Street that free money is like oxygen supply through ventilator. A person can survive only a few days on ventilator, isn’t it? QE acts in a similar fashion, albeit for longer durations. So, what next?
We saw this happening recently when the pandemic struck and all economies across were beaten. Central banks, including the Fed and RBI, embarked on measures to support the economy by reducing interest rates and putting more money in the hands of the people.
But, is there a possibility that the doles that the central banks give to the markets could be dialled back? Yes! Obviously, at some point in time, they have to stop distributing free money because when the economy revives, there is no need of oxygen line. This is when tapering comes into the picture. ‘Tapering’ is nothing but the Wall Street word saying stop infusing more money.
Something similar happened in 2008. The 2008 financial crisis triggered a long recession. At that time, the U.S Fed came up with the QE Plan. This helped keep the lending rates low and also increased liquidity in the economy.
Consequently, low lending rates encouraged more people to take loans and boosted spending. Then, once the economy showed signs of healing, the Fed announced reducing the QE program by 2013. This announcement created panic in the markets and that is how the word ‘Tantrum’ originated due to the overreaction of investors after the announcement.
Emerging markets including India, Indonesia, Brazil, and Turkey were severely hit by inflationary pressures in 2013 due to tapering. How? Allow me to explain. During the QE period, lending rates fell. Hence, those lending money in American market started looking at better places to park their excess money – which found its way into the markets like India. This led to an upswing in Foreign Institutional Investors (FIIs) in India.
Until one day in 2013, the Fed decided to begin tapering. As a result, American investors in India started to pull the plug on their investments in India as the interest rates in the U.S began to rise and gave them a better return option. Now, as FIIs pull out, the value of the Rupee depreciates. This forces RBI to hike interest rates. In turn, the US dollar becomes stronger, leading to a rising case of inflation in India.
The US Fed is currently buying securities worth US$ 120 billion from the market. This month the Federal Government is expected to start tapering by slashing their bond-buying program.
Note that, with retail investors driving the markets now and India’s economy doing relatively well, the stock markets seem to be in a good position as compared with 2013. Further, the RBI has prepared the Indian economy well enough by accumulating sufficient forex reserves to the tune of US$ 63,300 crore. That said, how this taper situation pans out remains to be seen.
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