The United States’ Federal Reserve is slowly going to begin cutting back on all the economic incentives it provided during the COVID-19 pandemic, its chairman Jerome Powell indicated this week. Let’s look at how this decision will impact the Indian market and economy.
The Federal Reserve – commonly referred to as the Fed – will start this cutback by slowly reducing its monthly purchasing of government bonds, which it does to stimulate the economy. This reduction will squeeze the amount of money circulating since the purchased bonds are swapped out for an equivalent amount of printed cash. The money is used for various purposes that drive the economy. For example, banks use the money to give out loans for businesses, who in turn conduct their operations that aid economic growth and provide jobs.
The central bank has bought bonds worth $120 billion each month to stimulate the COVID-hit U.S. economy. The increased purchase has brought liquidity into the financial markets and led to record gains across various stock indexes. The Fed’s accommodative policy has been replicated in other countries as well, including India, where the Reserve bank of India (RBI) has maintained its key interest rates, known as repo rates, at a historical low. These low interest rates make loans available at a cheaper cost to businesses and consumers, helping stimulate the economy.
However, as the economy expands, demand for goods and services rises, leading to inflation. Therefore, every central bank at some point after a period of low rates, decide to pull back on stimulating the economy. This is because unchecked inflation can lead to rise in prices of essential goods and services, leading to a further strain on the economy.
While the Fed has made similar reversals in policy before, nothing has been so dramatic. This remarkable change in stance from the world’s most powerful central bank has triggered questions of whether the accommodative economic stance seen across the globe by central banks would finally end.
India will be one of the most affected countries because of its dependence on foreign currency inflows in its own financial markets. A squeeze in bond buying in the United States will cause a domino effect where currency inflows into supply chains and, in turn, financial markets, will be choked. India, along with South Africa, Brazil and Turkey which depend heavily on foreign investment, will feel the pinch of such a decision.
But India has over $650 billion in foreign currency reserves and its current account deficit, the difference between the amount of exports and imports, is relatively low. This has left experts such as former Reserve Bank of India governor Duvvuri Subbarao to think that the taper will not cause too much tension in the Indian markets.
The Sensex also scaled fresh record highs, touching 60,000 points for the first time ever, just days after the Fed’s decision, showing that Indian investors have shrugged off any uncertainty about the taper policy. Investors have chosen to put their faith in the expanding Indian economy instead.
Strong fundamentals in Indian companies, the easing of coronavirus cases and rapid vaccinations are bound to keep Indian markets on an uptrend for some time, making it an attractive destination for investors worldwide.
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