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Professor Simply Simple explains “Fed Tapering”

7th February, 2014

Fabian owns a small bakery shop in Goa. His wife Suzi is a home maker and takes care of their two kids Jonny and Julie who study in college.

Fabian with great difficulty sets aside Rs. 15,000 a month for household expenses. This amount is sufficient to run the house but not enough to fulfill Jonny and Julie’s growing needs of entertainment and extra-curricular activities.

Jonny and Julie remain dejected and left out from their peers as they don’t have enough pocket money to spend.

Fabian cannot withstand his kids’ sadness and decides to increase the monthly household expenses. He sets aside an additional Rs. 5,000 a month as pocket money as long as the kids behave well, study diligently and score good marks in exams. He wanted to fulfill all their wishes and hobbies even though he had to put an extra effort to earn that incremental Rs. 5,000 every month.

This made Jonny and Julie happy as they could now do everything that their friends could do or afford. This positive energy reflected into their studies and they scored well in their college exams.

After some time, Fabian and Suzi decide that their kids are now ready to take on the challenge to earn their own livelihood and become financially independent. So, they decide to gradually reduce Jonny and Julie’s pocket money by 5% every month till the time they find a part-time job for themselves of their choice.

This process of gradual roll back of pocket money is similar to tapering under way by the U.S. Federal Reserve (popularly known as Fed).

What is tapering?

Tapering refers to the reduction in the quantum of the bond buying programme by the Fed.

The bond buying, also known as the Quantitative Easing (QE) program was launched to kick-start hiring and growth in the US economy. The Fed’s first QE program was launched in the midst of the 2008 financial crisis. (To learn about QE, click here)

But why is Fed tapering now?

The Fed’s decision to taper its massive bond buying is due the recovery in the US job market and the confidence that the economy will continue to grow despite the tapering.

Is Fed tapering a concern for India?

The tapering programme actually should not affect other countries because the QE programme was meant to stimulate the US economy really. But quite the contrary, it ended up being used to invest in emerging markets including India where returns were better.

Since India runs a large current account deficit, it depends on FII investment for funding.  Therefore any withdrawal of such funds would start to have repercussions on the forex position and this could eventually lead to a depreciation of the currency.

The important thing will be to observe how the foreign funds react in both the debt and equity markets on account of this tapering announcement.

On the positive side, the current account deficit has come down sharply with imports coming down, exports going up and external sector risks reducing considerably.

Thanks to the breathing space provided by Fed on the decision of tapering, India could utilise the delay to bring about adjustment in the current account deficit and built buffers by replenishing its foreign exchange reserves.

Only time will tell us how prepared are we to deal with the Fed’s tapering of its monetary stimulus.

Hope the above explanation would have given you an idea of the Fed tapering.

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