The U.S. Federal Reserve¡¯s gradual exit from so-called quantitative easing (QE) ¡ª open-ended purchases of long-term assets ¡ª 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 ¡ª and in other advanced countries, particularly the United Kingdom and Japan ¡ª drove down domestic interest rates, while flooding international financial markets with liquidity.
In search of higher yields, investors took that liquidity ¡ª largely in the form of short-term speculative capital (¡°hot¡± money) ¡ª 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.
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