Taper tribulations

When the United States Federal Reserve began what turned out to be a series of quantitative easing (QE) measures in October 2008, most observers would have seen it as a temporary crisis response measure, to be withdrawn as soon as it had done its job of calming markets and thawing out a credit freeze. This expectation would have been reinforced by the sharp recovery across global markets in March 2009. If this were to sustain, theoretically speaking, the liquidity overhang could have quickly fuelled inflationary expectations as the recovery in the real economy put idle resources and capacities back to work.

In the event, this did not happen and QE1 was followed by QE2 in October 2010. The recovery had clearly stalled and the upheavals in Europe were not helping confidence. As more indicators began to signal a possible double dip in the US, the Fed chose to provide a further stimulus, even as many emerging market economies were experiencing what appeared to be relatively robust recoveries. One important justification for QE2 from the US perspective was that abundant liquidity was simply not translating into higher inflationary expectations, for example, as evidenced by the yields on inflation-linked bonds. In other words, the system could absorb more liquidity without significant inflation risks.

Almost two years later, things still looked rather sluggish and inflation risks remained subdued. This promoted the third instalment, QE3, in September 2012, but with much more explicit signals that this could be the last. Specific quantitative benchmarks for inflation and unemployment rates were indicated as milestones to start to roll back. Not long after, in May 2013, came the first signs that the reversal was imminent and, since then, the question turned from if to when and how fast. In effect, what was seen in 2008 as a temporary move turned out to be exactly that, even if the “temporariness” lasted for five years!

How should markets have responded to these measures? The premise of market efficiency would lead one to infer that, if the liquidity infusion was seen to be temporary, its impact on asset prices should have been relatively small. Additional liquidity would have allowed a certain degree of normality to return to markets after the post-Lehman freeze, thus raising prices a little. However, given that it was expected to be rolled back at some point, a huge boost was unlikely. What should have boosted markets, if anything, was the prospect of a real recovery in response to the policy measures.

However, the evidence does not seem to bear this out. Despite the fact that QE2 and QE3 were carried out in situations in which prospects of recovery looked uncertain, they had an enormous impact on markets around the world. Equity, currency and commodity markets boomed, to the point where the US was accused of destabilising the recovery in emerging market economies because of sharp currency appreciation in the famous “currency wars” episode in late 2010. From the Indian perspective, the post-QE2 surge in oil prices, from about $85-90 a barrel to around $110 in early 2011, delivered a significant inflationary shock. And all these asset (commodities included) price increases seemed to pay little attention to the conditions in the real economy, particularly in the developed countries.

In short, one could infer from the evidence of the past five years that liquidity shocks have a significant impact on asset prices, even if they are known to be temporary. The discounting for temporariness does not seem to have taken place (I admit to not having a counterfactual for this claim). Given this, it is not surprising at all that the prospect of a rollback has caused exactly the opposite to happen. All the assets that boomed during the liquidity deluge are now crashing. Some others, like US equities and, strikingly, crude oil, are holding up because, presumably, the real economy drivers are now kicking in quite strongly.

What do these patterns imply for investors and policy makers? As regards investors, the sharp rise in asset prices in response to the liquidity infusions, despite the knowledge that these were “temporary”, suggests the dominance of short investment horizons in the post- crisis market environment. Everyone who believed that liquidity would take prices up even for a short while got into the act and this expectation became self-fulfilling as a result. Now, as the situation is reversing, a similar dynamic is at work in the opposite direction. Investors who have generated significant returns for themselves are now getting out while the going is good.

But this is not necessarily a one-way movement. The increasing prospects of recovery should bring in investors with a relatively long investment horizon, who find current valuations attractive in relation to business prospects. In effect, liquidity-driven investment strategies are making way for ones driven by fundamentals. This is not at all a bad thing. It is, if you will, a reversion to trend, pushing the hype and inflated valuations of the last few years into the background. It is usually good for productive investment when assets are valued by their fundamentals.

For policy makers, the challenge is to be able to ride out the storm while ensuring that their fundamentals are not weakened in the process. Even as the reallocations by short horizon investors cause enormous turbulence in asset markets, this must be seen as a passing phase, during which weak fundamentals are shored up and strong ones are protected. Of course, it is well known that severe short-term shocks, such as the one we are currently experiencing, can cause structural damage. It is also known that weak fundamentals will prevent an economy from taking advantage of the opportunities provided by the transition in investment horizons.

This is precisely the situation that Indian policy makers have to deal with. The turbulence will pass and a lower rupee may, for many producers, be a stronger rupee. But not all our constraints to competitiveness can be removed by the exchange rate alone. Garment or footwear manufacture, for example, will not be competitive even with the rupee where it is if they have to depend on diesel generators, even as diesel prices are rising. And if these constraints are not directly addressed, the global recovery that follows the taper turbulence will simply pass us by.