Federal Reserve: Fed’s slow tapering plan: Is it potent enough to

The US Federal Reserve (Fed) is expected to taper slowly over a period of time. Expectations are that around $15 billion would be reduced every month out of the current run rate of $120 bn a month of asset purchases. This implies that Fed balance sheet would actually continue to expand deep into the next year. US government deficit financing would also mean a continued expansion of the Fed balance sheet. We see the following panning out:

The US government has stopped giving unemployment benefits to the population. It is estimated that 7.5 million people would have received their last cheques in September. This reduces the fiscal deficit for the government and actually reduces the need for the Fed to continue buying government securities. Hence, in the first few months there is a chance that the yields will continue to remain at lower levels.

The job scene is buoyant. It is expected that most of the people seeking jobs would get one and hence the savings they may have accumulated during the taper period could continue/with sustained consumer confidence be used for consumption. Wages would increase tax revenues and reduce fiscal deficit. It helps that at the start point, the household leverage is lower and savings significantly higher than when taper was last experienced in 2013. The impact on US purchasing power should be minimal.

Fed asset purchases were probably more than what was needed and resulted in excesses around the world. This should be expected to normalize. However, if we see the trend of FPI flows, India has received only normal flows, around $45 bn over a period of 2019 to YTD, an average of around $17 bn assuming we get less than $10 bn in 2021. Versus this, we received $60 bn in 2012 to 2014 period, an average of $20 bn when our economy and markets were much smaller. Global liquidity sloshing around has probably missed India.

Moreover, the impact of foreign flows into Indian equity markets has been reducing over time and the direction of the market is now more determined by Indian money both institutional and retail. Indian money flow into equity has accelerated. MFs have been getting record inflows. Retail demat account additions are increasing at record pace. Given the low penetration vs rest of the world and a younger population, this trend could sustain. Indian markets would be directed by domestic flows vs international.

Reduced supply of money also makes USD scarce and it has a tendency to appreciate against other currency and investments return to the US. This causes other markets to see stagnation in market performance. However, even after taper has started, the US balance sheet would continue to expand for some time as asset purchases continue at a lower pace. Moreover, the balance sheet would contract only when the paper bought is redeemed and this also provides more time. This implies that other countries can also continue to keep looser than usual monetary policy if there is a need for the same.

The Fed has kept…