FOMC Extends Asset Purchase To $ 85 Billion Per Month

The US Federal Open Market Committee (FOMC) yesterday came out with a plan to buy long term treasury bonds worth USD 45 billion per month. The move is in addition to the Fed’s existing programme of buying USD 40 billion per month of mortgage-backed securities. This step will now infuse more liquidity into the system, thereby boosting consumer spending and in turn help the US economy grow. Since consumer spending accounts for 70% of the U.S., making liquidity available in the markets makes for a key exercise in efforts to revive growth.

Operation Twist, the on-going exercise to swap short-term debt for longer-term Treasuries is set to expire by the end of 2012. With this mechanism in place, the Fed would be continuing with one arm of the operation thus avoiding a lowering of the pace of asset purchases. The Fed expects these purchases to maintain downward pressure on longer-term interest rates, support mortgage markets and help make broader financial conditions more accommodative.

The Fed kept rates unchanged at a near-zero level. But what came as a surprise to the markets was its target setting for the key economic indicators of unemployment and inflation. According to the Fed it did this to give the market, guidance on when it will raise interest rates. It would hold rates till the unemployment rate falls below 6.5% and only if inflation remains below 2.5%. The time horizon for these indicators is in line with the Fed’s earlier sign of holding rates till mid-2015.

With the deadline for the fiscal cliff kicking in, around the corner, markets have been closely tracking developments on this front. In an effort to control the soaring fiscal deficit, there would be a series of tax raises and spending cuts that would bring the deficit down by almost USD 600 billion in 2013 (approximately 4% of the GDP). This is likely to push the US back into a recession.

The impact of falling off the cliff would be colossal having considered the above figures. Moreover, these actions would be on the fiscal front. The scale and nature of these steps would be out of the Fed’s actionable space to offset. Logically, pumping excessive liquidity in the markets or playing with interest rates wouldn’t be enough to cushion the direct effect of increased taxes. Fed Chairman, Ben Bernanke said that the fiscal cliff is a major risk factor that is harming investment and hiring decisions by causing uncertainty or pessimism and that the Fed doesn’t have the tools to offset that event.

Although the Fed seems to be on track towards restoring economic strength, a lack of a long-term plan to curb fiscal deficit will only result in fiscal action in an opposite direction, thus leaving the economy to helplessly take a downward turn. With just over a fortnight left for it to kick in, risk levels seem high. However, as we have witnessed in the past, one can expect action even on the very last day.

With the constant flow of liquidity into markets and the highly desirable positioning of emerging markets, we expect the inflow of funds to continue into India. So while the US grapples with its problems, it does seem to be a good sign for the Indian markets at least over the shorter term.