Over the past few days, expectations that the United States Federal Reserve Board's Open Market Committee would initiate its "tapering" policy during its two-day meeting were clearly moderating. The most recent US data suggested that neither unemployment nor inflation was converging as rapidly towards the thresholds that had been previously suggested as triggers for the withdrawal of liquidity. In the event, the Fed surprised many observers by not only maintaining the status quo but also giving no explicit indication of when the tapering was likely to begin. If anything, its statement emphasised its commitment to maintaining its exceptionally expansionary stance until the recovery showed clearer signs of sustaining. In essence, Wednesday's statement takes the situation back to what it was before the announcement on May 22 that it was time to roll back on liquidity.
After all the turmoil that the announcement precipitated in global financial markets, this statement should come as an enormous relief to policy makers in many countries who have been struggling to get some kind of grip on their rapidly depreciating currencies. The combination of the significantly lower risk of an attack on Syria, which has brought down crude oil prices, and the Fed's actions bodes well for a resurgence of capital flows into emerging market economies, with obvious implications for both currencies and other asset prices. On Thursday, the markets responded positively to the Fed's move; the Bombay Stock Exchange's benchmark index, Sensex, gained by over three per cent and the Indian rupee appreciated by 2.5 per cent.
This may be a source of comfort, but it is absolutely imperative that policy makers learn appropriate lessons from the events of the past few months. The fact that the tapering is not happening now only means that it will happen later; but happen it will. The behaviour of currencies, including, prominently, the rupee, vividly demonstrated the impact that a normalisation of global liquidity conditions would have on economies with a high degree of vulnerability. The most important symptom of that vulnerability is the current account deficit.
When tapering actually begins, if the vulnerability has remained the same or worsened, the impact will be commensurate. Policy makers in these countries must, therefore, use the extended time window provided by the Fed to reduce their vulnerability as quickly as possible. Otherwise, history will only repeat itself, with another round of turbulence very much on the cards. In this regard, the measures taken by the Indian government to clarify tax issues for multinational companies and impose constraints on public spending are welcome. But much more needs to be done, and quickly, to shrink the current account deficit.
Focusing on the mid-quarter review of monetary policy on Friday, the Fed's announcement gives the Reserve Bank of India (RBI) an opportunity to roll back the steps that it took to protect the rupee on the grounds that these are no longer necessary, at least for the time being. The tightening of liquidity conditions that these steps entailed may or may not have helped the rupee stabilise, but they certainly heightened the risks of a credit squeeze and, consequently, further pressures on already sluggish growth.
Restoring liquidity conditions to the pre-July 15 scenario will help reverse some of the impact on growth but, more importantly, let the RBI forcefully communicate its return to a more conventional growth-inflation trade-off as the basis for its policy decisions. This will be a welcome step in Governor Raghuram Rajan's first monetary policy review.
