The second round of quantitative easing (QE2) of 600 billion dollars announced by the US Federal Reserve last Thursday did not exceed expectations. Exchange rates should, in theory, be the first to capture the impact of policy-induced changes in liquidity. Currency movements across the board, however, remained muted in the wake of the announcement, reflecting the fact that it was almost exactly on anticipated lines. The sharp appreciation against the dollar in almost all currencies over the last two months thus seems to have factored in this shape and size of QE. The rupee, for instance, has remained virtually flat and the euro that tends to trade as the “anti-dollar” currency has actually lost against the greenback after QE2 was announced. Besides, despite the commitment to this massive monetary expansion, US longer-tenor bond yields either stayed flat or rose a tad. After a brief spell of post-announcement euphoria, equity markets also seem to have stabilised. All this seems to confirm the fact that this avatar of QE2 had been “priced into” the markets ahead of the actual announcement. It is thus possible that in the near term, QE2 will not give asset markets another huge adrenalin rush.
In the medium term, things could be different. QE2 is likely to achieve two things. For one, despite scepticism about the efficacy of this fresh flood of dollars on the “real” economy in the US, the announcement does signal that the US central bank is willing to pull out all the stops in tackling the recession and unemployment in the country. (It is possible that if this amount of dollar infusion does not work, the Fed will not balk at infusing more liquidity). This should help allay fears of double-dip recession and help risk appetite. Secondly, QE2 opens another spigot of cheap dollar liquidity that (if risk appetite stays healthy) will chase returns. Emerging markets like India are thus likely to see a steady flow of dollars that will threaten to erode currency competitiveness and blow up asset bubbles. Some of the dollar liquidity will boost commodity markets and this would add to inflationary pressures. Central banks that try to fight this with higher interest rates will invite more dollar flows on the back of rising interest rate differentials with the US. Thus, emerging market governments could be left with little option but to physically restrict the quantum of capital inflows though curbs on foreign investments and loans. This, in turn, could spark a wave of protectionism from the US and other developed economies. A currency war will morph into a trade war. One hopes that the G20 meeting scheduled this week will produce some resolution to this conflict before the sparks really start flying. India certainly needs to take a hard line, along with other emerging economies, towards the US’ strategy of recklessly printing dollars to unfreeze its own labour markets. QE2 may be a fait accompli. It is important from India’s perspective that QE3 does not follow.
