The term “tapering” has been going around for quite sometime in the financial market.  In last few weeks, this term of tapering has played havoc with Indian financial markets and made even our regulator, Reserve Bank of India, nervous.    The financial pundits even in India will be closely watching Federal Reserve Board Chairman Ben Bernanke when he testify before the Senate Banking, Housing  and Urban Affairs Committee hearing on “The Semiannual Monetary Policy Report to the Congress” at  Capital Hill in Washington on 18^th July, 2013   For the benefit of our readers, I am giving below some details which I am sure will make the subject easier for bankers and students and they will be able to appreciate the term better.

Background :

After 2008 financial crisis, Fed has been takings steps to bring the US economy out of woods by cutting rates to ultra low levels.   Such a policy  provided stimulus to the sagging economy through two programmes popularly known as (a) Operation Twist; and (b) Quantitative Easing or QE..   Out of the two, the latter one ie QE is more relevant  for our discussions today.    Under QE, Fed is purchasing  $85 billion of fixed income securities per month ($40 billion of mortgage backed securities, and $45 billion of US Treasuries).   Usually, the central banks do such activities across the world, for a limited periods say two-three months (or upto a fixed dead line).   However, in view of the deep crisis in US economy,   Fed’s QE programme  did not set any end dates, but the consensus was that Fed will begin to wind down i.e. “taper” the size of its purchase before the year is over with the goal of ending the programme at some point in 2014.   Since December, 2008, the Fed had been trying  to maintain a target rate not exceeding 0.25%.   It intends to keep the rates at this level until inflation rises to an annualized rate of 2.5% or unemployment falls to 6.5%.   Thus, Fed will continue with the current QE till incoming economic data does not meet the above targets. 

What is Tapering :

 “Tapering” has come to financial jargon when in  May 2013, Ben Bernanke stated that Fed may taper the bond-buying program known as quantitative easing (QE) in the coming months.   What he meant by tapering was that Fed will start reducing the amount of bonds being currently purchased by Fed.    At that time, Fed was purchasing $85 billion of bonds  per month.   The next meeting is on 18^th September and thus there were wide speculations that after 18^th September, 2013, Fed may reduce the size of monthly bond purchases to  $70 or $75 billion i.e. tapering to the extent of  $10 to 15 billion  Such a step is reducing the size of QE is being termed as “tapering”.

What are its implications for US and India :

Everybody knew from beginning that QE is not meant to last forever.   Thus, it has to come to an end once US economy signs of recovery.  Fed has rightly thought to bring the change slowly rather than stop the same abruptly.   Thus, it will be brought to end through ‘tapering’.

The mere statement of ‘tapering’ has sent shock waves in financial markets not only in US but also in India.   The shrinking of pumping of more money through regular purchase of bonds, will squeeze the liquidity and will impact the stock markets immediately.   The follow up of the tapering will show hardening of interest rates in US, which may even touch 3% in the medium range.   This increase in interest rates in US is likely to result in shifting of capital from India to US.   This can badly hit Indian stock and bond markets, and interest rates are likely to go up affecting the growth prospects of Indian corporate.   Moreover, the flight of capital from India will put additional pressure on Rupee which can again see sharper  depreciation and move towards Rs70-Rs75 range.

(The article will be updated after Fed meeting on 18^th September and RBI’s quarterly review of monetary policy on 20^th September, 2013)