The US Federal Reserve chief Jerome Powell in August this year announced that the bank could start tapering bond purchases this year. This bond buying taper could start in November-December this year, and would continue until the middle of next year.
The Federal Reserve started buying at least $120 billion worth of bonds every month since the Pandemic began in March 2020, adding $4 trillion to the Fed balance sheet. The reduced bond purchases will reduce liquidity in the markets worldwide including in India.
What is bond purchase tapering?
The bond buying programme is part of monetary policy in a bid to inject liquidity into the system. The US central bank injects money into the system by buying bonds through open market operations.
As commercial banks get access to more money, they get induced to lend it further to borrowers. And as the process continues month after month, more liquidity is added to the system and banks get more money to lend.
This cycle of liquidity infusion helps revive the economy with more people and businesses getting money to invest and to spend.
After the announcement of taper in August this year, the market participants are eyeing the next Fed meeting in November for further announcement. But one thing is certain -- that the tapering would trigger decline in liquidity in the markets worldwide.
How is this going to impact the Indian markets and participants
With tapering on the cards, there are speculations that the foreign exchange would move from Indian markets to overseas markets in run up to interest rate hikes.
As a matter of fact, bond purchases are part of quantitative easing that happens after interest rate cuts. Once the interest rates cannot be slashed any further, the Fed resorts to asset buying programmes to give further stimulus.
After the bond purchase programme is withdrawn, the next step will be to raise interest rates, that might happen a year later.
Tapering is a precursor to interest rate hikes – something that can lead to an outflow of foreign exchange from India.
Since RBI already has massive forex reserves (over $641 billion as on September 10, 2021), the impact of Fed tapering, whenever it happens, is expected to be muted.
Lessons from the past
Seven years ago when Fed chief Ben Bernanke on May 21, 2013 announced that the US central bank would cut down the quantum of bond purchases, the market went into a panic mode. From 2008 to 2013, the Federal Reserve was buying bonds worth $85 billion per month. Following the taper, it was cut down to $75 billion in December 2013. Then each subsequent meeting of the Federal Reserve committee led to a further tapering of $10 billion.
As we summarise, we can say that the bond purchase programme is a temporary phenomenon of the US Federal Reserve that is aimed to inject liquidity into the markets. The tapering can have short term fluctuations, but it is precursor to the economic recovery in the long run.
With massive foreign exchange reserves held by the RBI, the impact of outflow of foreign currency is expected to be muted.