Reform and Rebalance

Earlier this month, when the Federal Reserve Board met behind closed doors to decide whether to ease up on its open-ended asset purchases, the financial world held its breath. Will it or won’t it? Emerging markets prepared for the worst as did recession-hit Europe. The Fed tapering its easy money policy could mean disastrous tightening elsewhere. There was, thus, an almost audible sigh of relief from the world over when the Fed said no tapering yet. 

Given the still weak recovery and the looming threat of yet another “whale of a fight” (as the Republican Speaker threatened) over debt ceiling, Fed backed away from its taper plan. Four years into the economic recovery, it was obviously not yet time to remove the training wheels. And judging by the US economic outlook, the policy of stimulus may outlast Fed chairman Ben Bernanke, whose term ends in January 2014. 

When, in June, Bernanke first raised the prospect of tapering the monthly purchase of $85 billion assets, the threat of rising interest rates jolted bankers and financial markets. Specially affected were emerging markets which had attracted investors looking for higher returns than the measly yield of US debt. (Since 2009, a total of $3.05 trillion was pumped into emerging markets). While announcing the asset purchase plan in 2012, Bernanke said it would continue until there was a “substantial improvement in the labour market outlook”. A year later, the US economy looked brighter with unemployment down to 7.4 per cent, from 7.6 per cent. In anticipation of the US economy rebounding, some $86 billion is estimated to have left Asian markets, making the Indian rupee, Indonesian rupiah and other currencies tumble.

 The bright outlook of June, however, has since darkened. Timid job growth meant unemployment still stood at 7.3 per cent, well above the target. The GDP forecast too was downgraded from 2.7 per cent to 2.5 per cent. Although Bernanke held up the possibility that if unemployment rate fell to 6.5 per cent or inflation started to rise, the Fed would begin winding down its asset purchases, there seems very little realistic hope of that happening any time soon. 

Not only do the US macroeconomic prospects look cloudy, economic trends do not portend any robust job creation. Structural changes in the economy seems to be creating mostly low-paying, non-tradable jobs with a lot of semi-skilled jobs disappearing due to automation and robotics.


Factories are increasing productivity but relying on robots. Airlines have substituted ticket agents with online sale and check-in booths. Supermarkets are increasingly replacing sales clerks with auto-checkout machines. More immediately, continuing political deadlock in Washington threatens to drag down the economy. Sequestration or across-the-board spending cuts in effect since March, resulting from disagreement in the Congress, have produced layoffs and slowed growth. The looming Republican-Democrat battle over increasing federal debt ceiling and the prospect of a shut down of the government is further darkening the outlook. 

Ironically, Republican hardliners’ desire to scrap the stimulus in order to halt the ballooning US debt is producing the opposite result. The slowdown of the economy their combative tactics portend is one reason why the Fed has decided to carry on with the asset purchase plan. The unintended consequence of the Fed’s decision has been to bring relief to developing nations. As US markets brace for more self-inflicted blows to the economy from a quarreling Congress, jittery foreign capital is likely to trickle back to the emerging markets they had earlier fled from. The Fed’s decision effectively means stimulus for all. Currencies that tumbled have begun to steady themselves, and delighted at the reprieve, stock markets have taken off as if it is again party time. 

The exuberance may lead developing countries to forget that unless they reform and rebalance their economies, the partying on the Fed’s tab could be short lived.