Scaling Back Quantitative Easing: Domestic Recovery at a Foreign Cost

One of the more controversial policy responses to the financial crisis is the Federal Reserve’s policy of quantitative easing (QE). In this policy, the Federal Reserve buys long-term Treasury bonds and Mortgage Backed Securities as a way to inject money into the US economy and counteract the deflationary effects of the recession. While this expansion of the monetary base has stimulated housing market recovery, employment growth, and a general improvement in US financial conditions, a primary concern is how to scale back these expansionary efforts without deleterious economic consequences. This scaling back or “tapering” process may be a sign of domestic economic recovery but has coincided with significant adverse effects internationally in emerging market economies.

In “The Transmission of Federal Reserve Tapering News to Emerging Financial Markets” Joshua Aizenman, Mahir Binici, and Michael Hutchison analyze the effects on asset prices in emerging markets of public tapering announcements by Fed officials. The authors find that tapering announcements resulted in substantial decreases in stock market indices and large exchange rate depreciations in these countries, suggesting an anticipatory response to reduced inflows of US dollars.

In December 2013, the monthly purchase of bond-buying totaled $85 billion, but the Fed announced that it would begin decreasing this level by $10 billion a month and would conclude buy-back efforts at the end of 2014. The Federal Open Market Committee recently confirmed  another decrease in these asset purchases from $55 to $45 billion during May 2014.

Aizenman et al. analyze market responses to tapering by studying financial asset prices in 27 emerging market countries where QE created large short-term capital inflows of US dollars and led to the widespread use of US currency to fund large-scale trade. The authors track daily changes in national stock market prices, exchange rates, and credit default swap (CDS) spreads in the 24-hour window after tapering news is released between November 2012 and October 2013, two months prior to the official implementation of tapering.

Interestingly, the 10 tapering statements made by Fed Chairman Ben Bernanke and the Federal Open Market Committee had the strongest impact on financial indices in emerging markets, likely acting as a clearer signal of the Fed’s official policy stance in comparison to more frequent and sometimes contradictory statements from Federal Bank Presidents.

On average, Bernanke’s statements had the most substantial impact, resulting in a 33 percent decrease in stock market indices and a 21 percent increase or depreciation in exchange rates. Surprisingly, countries with comparatively “robust” economies, characterized by current account surpluses, high international reserves, and low external debt, suffered asset price declines nearly three times greater than “weaker” countries in the sample. Additionally, stronger countries experienced significant increases in CDS spreads, reflecting greater uncertainty and risk in the their sovereign bond markets.

These differential results imply that the threat of tapering had the worst initial impact in countries that received the most capital inflows from QE. Markets in these countries immediately responded to the anticipation of large outflows from tapering. Counter intuitively, stronger financial fundamentals did not provide insulation from these speculative effects because robust economies benefited most from QE and thus would potentially suffer worst from tapering. Although weaker markets were less impacted initially, the authors note that these countries, particularly the “Fragile Five” Brazil, India, Indonesia, South Africa, and Turkey, will likely suffer in the longer run as more robust economies are better able to sustain short-term asset price volatilities and adjust from capital outflows.

The global power of the US Federal Reserve is further confirmed by the financial impact of its public messages on emerging market economies. An extension of the timeframe of this analysis may help clarify the economic impact of the actual implementation of tapering as well as any differences in the impact of statements from the newly appointed Chairman Janet Yellen. Additionally, the precarious economic position of the “Fragile Five” solidifies the importance of these findings and the necessity for further research on the residual implications of tapering for emerging markets and the ability of these countries to adjust.

Source: “The Transmission of Federal Reserve Tapering News to Emerging Financial Markets“. Joshua Aizenman, Mahir Binici, and Michael M. Hutchison, National Bureau of Economic Research, Working Paper, March 2014.

Feature Photo: cc/(Alex Griffiths)