Fed tapering may not unnerve financial markets

After bullying the markets for months about tapering its quantitative easing (QE) programme, the Federal Reserve will finally say today whether it will start to rein in its massive stimulus of the economy, which has flooded financial markets with some $2.75tn over the past five years. Given the US economy’s recent sluggish performance, concern over the Syrian meltdown, volatility in emerging markets and a feud between the White House and Republicans over fiscal policy issues, the Fed is expected to be cautious in easing its QE measures. Markets have generally priced in a $10bn cut in the Fed’s $85bn monthly purchases of long-term US Treasuries and mortgage-backed bonds.

Investors bracing for the Fed to wind down its monetary stimulus have fled emerging markets in recent months. The MSCI Emerging Market Index fell some 12% between May and September, the worst four-month stretch in more than a year for the index, which did regain some ground in recent sessions. So far the pain has been most acute in countries such as India, Turkey and Brazil, which are struggling with rising inflation and sluggish growth. Central banks in Indonesia, Turkey, Ukraine and India have seen the fastest erosion of foreign currency reserves since late May, according to Morgan Stanley calculations.

Emerging markets themselves, to a great extent, are responsible for the mess they are in now by over-depending on hot money inflows to boost growth at the expense of structural reforms. But it may be too early to say the emerging markets party is all over. While few are growing at double-digit rates these days, they can still outpace advanced markets for years to come. The International Monetary Fund expects emerging market growth of 5% this year, about four times quicker than advanced economies, and 5.4% next year. Some also argue that most emerging countries are better prepared now than they were during the emerging market crisis of 1997. A larger stash of currency reserves - about $7.5tn as of March compared with about $600bn in 1997 - also provides a cushion.

Fed chairman Ben Bernanke has argued that the growth windfall from the QE rounds would be more than sufficient to compensate for any destabilising hot-money flows in and out of emerging economies. Yet the absence of any such growth windfall in a still-sluggish US economy has raised questions about the policy effectiveness of QE.

Some experts argue the impact of tapering would largely be determined by “why the Fed is tapering.” It would be good for global growth if the US central bank is winding down its monetary stimulus for “good” reasons; that the central bank has strong reasons to believe the US economy will be on a firmer footing. The taper would, then, signal that, after years of sluggish growth, the US is resuming its role as the engine of global growth. But the Fed could taper for “bad” reasons too. If it thinks that the prolonged experimentation with unconventional monetary policy threatens to create too much collateral damage and unintended consequences, the taper would indicate growing policy ineffectiveness.