Prepare for QE3. That’s the message for emerging market policymakers emanating from the Federal Reserve’s Open Markets Committee meeting yesterday.
The FOMC announced in its post-meeting statementthat it expected rates to remain on hold until late 2014 at the earliest, compared to its previous guidance of “mid-2013”, adding that it “expected to maintain a highly accommodative stance for monetary policy”.
While the Fed did not announce any additional quantitative easing at yesterday’s meeting, it strongly hinted that such a move may well be in the pipeline:
| The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability. |
In other words, any further stimulus will likely take the form of a further round of QE.
Fed chairman Ben Bernanke confirmed this in the post-meeting press conference. In response to a question on the Fed’s willingness to enact further QE, he said that the Fed was "prepared to take further steps in that direction if we see that the recovery is faltering or if inflation is not moving toward target".
Analysts expect that such a move will likely occur in late Q1 or early Q2 2012. According to Capital Economics’ chief US economist, Paul Ashworth:
| We anticipate that a QE3 focused on buying mortgage-backed securities will be announced at either the March or April meetings. |
EM assets rallied on the back of the Fed’s announcement, with the MSCI Emerging Markets Index gaining almost 1% following the Fed’s announcement to hit its highest levels since late October.
Expectations of prolonged near-zero interest rates and a further round of quantitative easing in the US – coupled with the likelihood of further liquidity moves by the European Central Bank – have reignited expectations of an increase in inflows to EM asset classes in the coming months, as low returns in developed markets may push investors into EM asset classes. EM asset classes, equities in particular, have already seen significant net inflows this year, following significant outflows in 2011, suggesting a turnaround in investor sentiment. According to Barclays Capital, net foreign equity inflows into Korea, Taiwan, India, Indonesia and the Philippines have totaled $7 billion over the past four weeks – equivalent to 44% of the total outflows of $15.6 billion recorded in 2011.
And while this pace may not be maintained, with many analysts believing that the current risk rally will likely prove difficult to sustain given the significant risks, particulary regarding the eurozone, another round of QE would almost certainly prompt further flows to EM.
According to Komal Sri-Kumar, chief global strategist at TCW group, via Bloomberg:
| Bernanke set an implicit inflation target of 2 percent per year. If that means that the Fed will start a QE3, that move would, indeed have the impact of pushing up emerging market equity prices. |
Already priced in?
Against this, though, some analysts believe that policymakers and investors have anticipated a further round of quantitative easing by the US for some time now and that it therefore would not have as large an impact as the previous two rounds.
Here's Nomura's EM economist Peter Attard Montalto, as told to Emerging Markets:
| The US QE view has been accepted in policy makers minds. We've already had two bouts of QE in the US, so any third bout is likely to be of less impact and easier to price. |
However, he suggests that the prospect of further liquidity action from the European Central Bank has more potential to create volatilty and unpredictability on markets.
| Given the rhetoric and legality issues, ECB QE would be a new thing - even though one might argue that LTRO was already a form of QE-lite - so the market impact of the ECB action on EM will therefore be greater than US QE. |
Policy implications
While the prospect of an EM asset rally and further inflows spurred by QE in Europe or the US would likely be seen as good news by many emerging market policymakers in the short-term – Indian central bank governor Duvvuri Subbarao warned earlier this weekthat continued capital outflows could pose a “significant threat to [India’s] macroeconomic stability” – it would undoubtedly complicate the policy picture across emerging markets still dealing with the fallout from the last round of QE.
While policymakers across EM have begun easing in earnest in a bid to support growth and amid signs that inflation has peaked, the prospect of potential inflows spurred by QE in the West leaves policymakers facing a tricky balancing act in the coming months: responding to the slowdown in the near-term while guarding against the risks of a return of stimulus-fuelled capital inflows as the year progresses.
Standard Chartered’s Will Oswald encapsulated this policy dilemma in a recent research report. He wrote:
| Policy makers across emerging markets face a difficult set of choices ahead: respond to the slowdown via fiscal and monetary stimulus, or prepare for significant developed-market (DM) monetary stimulus and potential inflationary pressures. We expect the former to dominate until end-Q1, but inflation risks are likely to re-emerge during the remainder of the year. This also raises the potential for a shift back towards macro-prudential measures, including stricter capital controls. |
And in light of a string of warnings from the World Bank, IMF and regional development banksabout the likelihood of a significant growth slowdown across emerging markets this year, the challenges appear immense and the risks posed by policy missteps are equally elevated.
Our message to EM policymakers: good luck. It looks like you're going to need it.