Dec 19, 2013 | 01:01 GMT

5 mins read

The U.S. Federal Reserve and the Taper

It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.

The U.S. Federal Reserve announced the long-anticipated beginning of what has become known as the "taper" Wednesday. The press conference announcing the decision, the last by outgoing Federal Reserve Chairman Ben Bernanke, allowed a peek into the mindset of an institution that has an almost mythical place in global economics. The Federal Reserve controls the dollar, and the dollar rules the world, or so the story goes. Indeed, the Federal Reserve has an enormous influence on increasingly complex and volatile global capital markets, which has very real implications for countries all over the world. 

Despite its global impact, the Fed is only really able to take into account the state of the domestic U.S. economy in its calculations, and even that is done in an environment of mercurial data and with no ability to affect fiscal decision-making. In essence, the Fed makes world-changing decisions with an inherently narrow focus, flawed data and limited tools to accomplish the task at hand. That the Fed has limited powers is not to say that it is inherently bad in any way. The complexity of the factors in play makes it impossible for any one institution to be able to anticipate every effect of its actions.

What is a Geopolitical Diary? George Friedman explains.

Wednesday's announcement marks the beginning of the end of an unprecedented monetary expansion project undertaken in an effort to simulate asset demand and keep the U.S. economy afloat during the financial crisis. At $10 billion monthly, the actual volume of asset purchases being taken off the market is relatively small. The Fed plans to continue to purchase $75 billion in mortgages and Treasury bills for an undefined period of time, and will maintain lending rates between zero and 0.25 percent until unemployment in the United States falls to 6.5 percent, and perhaps significantly further. While U.S. growth in 2014 is expected to be slightly stronger than in 2013, the end to low growth is by no means in sight, so the process of tapering asset purchases could take a year or more. 

There is some urgency underlying the Fed's decision. Monetary expansion is an important tool for any central bank, but the implications of such a long-term expansion are not well understood. There is some danger that prolonged expansion will trigger significant inflation. This risk is a very real one in most countries, in instances when monetary expansion is used to finance fiscal obligations. But there is a nearly insatiable demand for the dollar, both as a reserve currency and a trade-financing tool. It would take a sharp reduction in demand for the dollar for the Fed's expansionary policy to translate to high inflation. There does not appear to be such a shift coming, but uncertainty prevails. Certainly, weakness in China as it manages an epic economic evolution is a strong potential disruptor, as is the ongoing social and economic malaise in Europe as the eurozone struggles to preserve itself.

Meanwhile, several other major economies have undertaken similar policies, including in Europe, Japan and China. Leaders of smaller countries around the world have decried monetary expansion and competitive devaluation as unethical, begger-thy-neighbor policy decisions. But these policies have also injected extra demand into global capital markets that has created a cascade effect where investors who otherwise would have chosen treasuries or mortgages have instead put money into higher risk, tradable assets in mid-level countries in a bid for a higher return.

At the same time, monetary expansion cheapens money by expanding the supply, and cheaper capital means that more countries have access to it. As a result, several countries developed current account deficits in effect paid for by monetary expansion-fueled financial flows, including Brazil and Indonesia. The initial announcement earlier this year that the Fed would soon taper caused these markets to roil, exposing fundamental weaknesses. Countries with vulnerable trade deficits — like Turkey and India — have since been dealing with serious currency challenges. These states remain vulnerable. Even beyond the difficulties that will accompany current and future tapering, they face the need for structural reforms to cope with the new environment.

The many months of lead time ahead of the Fed's decision to begin tapering asset purchases may mean that the bulk of the financial adjustments have already been made to take into account the change in policy. But it is the nature of the market that actions have reactions, and as the Fed pursues the taper, it will contribute to shaping and reshaping the landscape of the financial system in ways that will not be immediately obvious. The taper is an indication of increased confidence in the U.S. market, it opens up opportunities for investors looking for a safe asset to not have to compete with the Fed's purchases. But it makes a bet that capital markets have recovered enough to take up the slack and that is an inherently volatile process. 

Many countries are vulnerable to shifts in global capital flows, particularly in this time of global adjustment as the major economies, like the United States, make globally significant monetary decisions in pursuit of their own self-interest. Ultimately, the Fed mandate is to care for the health of the U.S. economic system, even though decisions made today in Washington will impact Indian, Turkish and Brazilian traders tomorrow. Thus is the nature of an anarchic international system.

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