Five years ago Lehman Brothers collapsed kicking the financial crisis into high gear. Since then central bankers around the world have been tripping over themselves to first stop the collapse and then re-inflate the global economy. The main weapon in their arsenal has been to lower rates and increase money supply by buying bonds. While the UK, EU and Japan are still at this stage, the US appears to be moving to the next. The US economy has recovered sufficiently enough for the Fed to consider removing some of the special measures that were created to support it. The US Fed is looking to begin tapering off its QE program over the next year or so.
What exactly is QE, you may wonder. In very simple terms the Fed has been buying up US government debt, thus increasing money supply and keeping borrowing rates low. Tapering would involve reducing the amount of bonds it purchases every month. Though this doesn’t sound like a significant move, remember the Fed is buying $85 Billion per month or roughly 8X the entire GDP of Zimbabwe. Money on this scale can distort the entire global economy and will cause a significant change to markets when it is withdrawn.
We have already begun to see this as emerging market currencies have tumbled ever since it became widely known that the Fed was looking to end QE. Over the last few years, the easy availability of money from the Fed and other central banks has created large capital inflows into the emerging market. This allowed several developing countries to run up large current account deficits without suffering significant currency depreciation. If those inflows were to cease, these trade deficits would be unsustainable as we have seen. Over the long term, weaker currencies will cause trade deficits to fall as exports become cheaper and imports more expensive. In the short term, however, we expect inflation and thus the cost of living to spike.
Over the last 5 years, we have lived through an exceptional period in terms of economic policy and it is probably right that this ends as soon as is feasible, but the fact remains that it will cause significant disruption to the global economy. Emerging economies must brace themselves for a couple tough years before we see a return to stability.