This reduction was expected by the majority of forecasters and, yet there was panic in the emerging markets, including Indian stocks that took a beating on Thursday. Why? For one thing, the Fed seemed somewhat uncharacteristically upbeat on the US' growth prospects using phrases such as ''household spending and business fixed investment advanced more quickly in recent months". This could mean that the pace of tapering could intensify going forward, leaving less money on the table for financial markets than they had factored in.
The fact that there has been a slew of bad news from the emerging world over the last few weeks did not help either. Argentina's currency went into free fall in January in response to growing concerns about an implosion in its economy (including default on sovereign debt). Argentina, incidentally, vies for top honours in the league of the world's most mismanaged economies. There are also deep concerns about China's banking system, particularly its shadow banks and a possible default by a Chinese bank, China Credit Trust, in the next few weeks. The Turkish central bank decided to raise its key overnight rate by 4.25 per cent to protect its currency and ensure that its massive current account deficit of over six per cent of gross domestic product was funded by capital flows.
That the Fed remained unmoved by the tumult in the emerging world and went ahead with yet another taper confirmed to investors that the it will (perhaps justifiably) focus on the US' own macroeconomic dynamics, and not be swayed by the collateral damage that its actions cause in the rest of the world.
It is important to remember that all this is happening at a time when the mood is bearish towards emerging markets as a whole and positive towards the US, which seems to be on the cusp of a significant recovery, and also Europe that is showing signs of a pulse. Japan seems to have settled at a fairly cosy level of 1.5 to two per cent and is back on the "must invest" list of global institutions. In short, emerging markets face a double whammy of shrinking dollar liquidity and negative sentiment.
However, there are emerging markets and then there are emerging markets. Analysts advise a nuanced view of emerging markets in choosing where to invest and where to sell off. The worst off are the so-called "serial mismanagers" (to coin a phrase based on think tank Capital Economics' recent analysis) such as Argentina, Ukraine and Venezuela that are likely to be punished the most.
The BIITS (Brazil, Indonesia, India, Turkey and South Africa) are also vulnerable given their current account deficits and the political risk of impending elections in all these economies by a strange stroke of coincidence in 2014. China with its myriad problems, particularly its dodgy shadow banking system also looks weak. But there are those whose outlook is brightening like Korea, Philippines and Mexico where a combination of reform and export prospects could attract capital. India's currency or stock market has not fared too badly vis-à-vis some of its BIITS peers in the recent episode of turbulence. This possibly reflects renewed investor faith in our external management capabilities. If we get our fiscal act together and a somewhat stable government, we might just be able to move to the "bright outlook" category.
There is a further twist to this tale. The Fed is withdrawing liquidity somewhat rapidly but trying to ensure that this does not lead to an interest rate squeeze by assuring the markets that hiking its policy or the "Fed funds rate" is the last thing on their minds.
This "forward guidance" has led the markets to believe that an actual rate hike by the Fed will have to wait until the second half of 2015.
But some analysts are questioning the credibility of this forward guidance. Here's the rub. The Fed is assuming "full employment conditions" (not zero but 5.5 per cent or the natural rate of unemployment) to prevail in 2016. This means that growth is likely to pick up pace as we go along and most likely breed inflation pressures since capacity utilisation is also picking up. However, at this stage, the Fed is content with assuming virtually no rise in inflation impulses from current levels. Typically, a full employment situation is associated with over four per cent levels for the Fed funds rate. Thus, if the Fed's inflation forecasts go wrong and the inflation does cross the two per cent mark, the Fed just has six months to hike its policy rate by four percentage points, if indeed it refuses to touch the policy rate until the middle of 2015. Will the Fed indeed be comfortable doing this or is a rate hike earlier possible? If indeed the Fed contemplates this and the markets start pricing this in, there could be more bloodletting for the emerging world.
The writer is with HDFC Bank.
These views are personal