US Fed announces USD 600 bn bond purchase : India Implication by Edelweiss

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The US FOMC announced a fresh USD 600 bn bond purchase programme and left the benchmark interest rate unchanged. The size of the purchase programme was largely in line with market expectations. The move is positive for risky assets including EM equities in the near term, although QE-2 may prove to be less effective than QE-1 given the fact that during the latter, the global economy was extremely weak, borrowing costs were high and asset prices were depressed, which is not the case now.  Below are key details.

n  Key details of the announcement

The US Fed announced quantitative easing (QE-2) under which it will buy longer-term US treasuries (average duration between 5 and 6 years) of USD 600 bn by Q2CY11 at the rate of USD 75 bn per month. Further, the Fed will continue to re-invest the principal payments from agency/mortgage debt into US treasuries, amounting to ~USD 35 bn per month. It aims to “promote a stronger pace of economic recovery and help ensure that inflation, over time, is at levels consistent with its mandate”. However, the Fed did not mention any explicit inflation target.

n  Key channels of impact on economy and their effectiveness

With its latest bond purchase programme, the Fed, by lowering borrowing costs, aims to spur domestic economic activity and boost inflation/inflation expectations. However, the effectiveness of this channel is doubtful given that despite record low interest rates, US consumers are paying back debt (for 9 quarters now) as uncertainty of incomes and jobs remain high and home prices remain depressed. Therefore, flushing commercial banks with additional reserves, over and above USD 1 tn of existing reserves, may not boost borrowing activity meaningfully.

Second, the Fed’s action is likely to boost asset prices, particularly equities, (although any meaningful appreciation in real estate remains doubtful) thereby boosting the wealth effect. This may support private consumption and hence have some stimulative impact on the economy. Third, the Fed’s action will induce depreciative bias in the USD, which in turn is healthy for the US exports. However, persistent USD weakness will be met with resistance from EM central banks, which in turn could lead to currency tensions mounting globally.

Overall, we believe that QE-2 may prove to be less effective than QE-1 given the fact that during the latter, the global economy was extremely weak, borrowing costs were high and asset prices were depressed, which is not the case now.

n  Implications for India

In the near term, risk assets in general and EM equities including India in particular are likely to benefit from ample global liquidity and associated high risk appetite. Moreover, capital inflows will support India’s widening current account deficit. However, surge in capital inflows beyond the economy’s absorptive capacity will create fresh monetary policy challenges such as upward pressure on INR, which hurts the export sector. Second, the Fed action is likely to boost global commodity prices, which in turn may jeopardize the softening trend in domestic inflation. Third, excess capital inflows trigger sharp upward movement in asset prices in a short span, thereby increasing the risk of financial instability in the economy.