Rather than cheap money promise, experts say markets want cues on US action to address debt and deficit levels over long term.
Emerging markets such as India may have to brace themselves for the effects of stronger currencies and higher commodity prices, leading to higher inflation, following the US Federal Reserve’s announcement on Tuesday that it would keep interest rates at current near-zero levels till at least mid-2013.
Stock markets in the US reacted erratically to the move, with the Dow Jones Industrial Average index finally ending the day over four per cent higher, a day after a dramatic plunge took stocks to their lowest level since late 2008. Analysts said the only revelation in the Fed’s statement was the inclusion of a specific time frame, as previous statements had indicated it would keep rates “exceptionally low for an extended period”.
“It’s warm beer,” said Paul Christopher, the St. Louis, Missouri-based Chief International Investment Strategist of Wells Fargo Advisors, referring to the lack of any new initiatives in the Fed’s announcement. He argued that after the end of the quantitative easing round called QE2, earlier this year, there was no new liquidity in the market. He believes the Fed should have started buying more securities or put money into the system by other means.
“The next step from the Fed needs to be better than QE2,” said Christopher, warning, “It could take only a modest shock next time to destroy confidence.”
The Fed’s decision to define a time frame for the first time is also being seen as a signal that it expects US growth to remain weak for at least that duration. The US government said last month the growth in gross domestic product (GDP) was an annualised rate of 1.3 per cent in the second quarter of 2011, and revised first quarter growth down to just 0.4 per cent, from the initial estimate of 1.9 per cent.
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While observers say growth and corporate profits will determine the stock market’s direction in the long term, some believe short-term government actions could boost confidence. David Malpass, a former chief economist at Bear Stearns and president of the New York-based research firm, Encima Global, wants US President Barack Obama to consider steps like reducing the tax rate on repatriation of offshore corporate funds in order to unblock these. “The idea has worked before, has bipartisan support, and would strengthen the dollar and cause an equity surge,” according to Malpass.
Meanwhile, the Fed policy could help India benefit from increased inflows from foreign institutional investors and US investors looking for higher yields. “This will create a tailwind for foreign investment into India,” says Christopher.
He cautions, however, that India’s “engines of growth, including consumer and government spending, have all shifted to a lower gear simultaneously” of late. While he believes growth in emerging markets will help counter the slowing in the US and Europe, Christopher says if the US falls back into a recession, many emerging economies will not be able to avoid recessions of their own.
The dollar plunged after the Fed’s statement on Tuesday, following another blow dealt by last week’s downgrade of the US credit rating to AA+ from AAA by rating agency Standard & Poor’s. But analysts don’t expect the dollar to lose its status as the global reserve currency in a hurry. A report from Bank of America-Merrill Lynch, issued after the downgrade, said: “We do not expect emerging market central banks to rush to unwind their dollar holdings. In the face of a weakening global economy, we expect foreign governments to continue to resist weakness in the dollar as part of their export-led growth strategy.”
Christopher noted that several other countries had been more active than India recently in efforts to weaken their currencies. While both the S&P downgrade on Friday and the Fed announcement on Tuesday were followed by big market moves, analysts believe the events themselves were not the catalysts, as they were not completely unexpected. Rather, markets round the world will look for cues in plans by the US to bring down debt and deficit levels in the long term.
Malpass strikes a pessimistic note on this front, stating, “We expect the US to continue ultra-loose spending and monetary policies, with a harmful impact on the dollar, investment in the US, GDP growth and employment. Under the current federal spending system (no controls or effective process to make budget decisions), we expect the marketable debt-to-GDP ratio to rise rapidly toward 100 per cent in 2021.”