Who’s Afraid of Tapering?

TOKYO – The US Federal Reserve’s gradual exit from so-called quantitative easing (QE) – open-ended purchases of long-term assets – has financial markets and policymakers worried, with warnings of capital flight from developing economies and collapsing asset prices dominating policy discussions worldwide. But, given that most major economies operate under a flexible exchange-rate regime, these concerns are largely unwarranted.

The logic behind the fear of the Fed’s “tapering” of QE is straightforward. Unconventional monetary policy in the United States – and in other advanced countries, particularly the United Kingdom and Japan – drove down domestic interest rates, while flooding international financial markets with liquidity. In search of higher yields, investors took that liquidity – largely in the form of short-term speculative capital (“hot” money) – to emerging markets, putting upward pressure on their exchange rates and fueling the risk of asset bubbles. Thus, the Fed’s withdrawal from QE would be accompanied by a capital-flow reversal, increasing borrowing costs and hampering GDP growth.