Effectiveness of Quantitative Easing (QE)

Last week, October 29, 2014, the U.S. Federal Reserve (Fed) concluded its $4 trillion QE programs   saying "there has been a substantial improvement in the outlook for the labor market" and "there is sufficient underlying strength in the broader economy". Many economists’ opinions on QE are divided,  some arguing in favor of it and some against it. Let’s have a look at the things, how they unfolded…

How it all started?

It all started with 2007-2008 financial crisis, to avert the ripple effects of the crisis, Fed started with reducing its fed fund rate and ended up with pumping trillions of dollars of money through three QE programs. After New Century Financial Corporation, a leading subprime mortgage lender, filed for bankruptcy in April 2007, rating agencies became cautious and started downgrading subprime mortgage bonds. Looking at the financial markets’ nervousness and to maintain the liquidity in the system, Fed started with 50 basis points cut in fed fund rate to 4.75% in September 2007 and by April 2008 fed fund rate touched 2%. Within 8 months, Fed reduced its interest rates by 325 basis points.

On September 7, 2008, the Treasury department took control of mortgage giants Fannie Mae and Freddie Mac and pledged a $200 billion cash injection to help the companies cope with mortgage default losses.

World financial markets spooked on September 15, 2008, when Lehman Brothers filed for Chapter 11 bankruptcy protection. As result of Lehman collapse, global money market immediately dried up, equity markets routed like there is no tomorrow, bonds and dollar skyrocketed. After seeing this, U.S. government, Treasury department and Fed took various measures to calm the financial markets.

Immediately after Lehman collapse, Fed and the U.S. government helped the one of the world’s largest insurer, AIG with $85 billion. In other words, AIG was bailed out by Fed and the U.S. government.

Within matter of three months, Fed reduced fed fund rate by more than 175 basis points to keep it between 0 to 25 points in December 2008. In between, when fed fund rate was about reach near zero levels, Fed started realizing the liquidity trap problem in traditional monetary approach. Ben Bernanke at helm of the Fed, who extensively studied Japanese lost decade and 1930s the great depression, started thinking of unconventional ways to pump the money into the economy.

QE1, QE2 and QE3

QE1 began in November 2008, with Fed deciding to buy $500 billion worth of mortgage backed securities (MBS) from financial market participants, $100 billion worth of debt obligation mortgage buying from giants Fannie Mae, Freddie Mac, Ginnie Mae and Federal Home Loan Banks. Fed did extend another $100 billion to Fannie Mae, Freddie Mac and Fed also announced the purchase of another $300 billion worth of long term treasuries. When QE1 ended in first quarter of 2010, Fed almost spent about $100 billion every month on buying mortgage backed securities for 17 months. That means, Fed was sitting up on about $1.7 trillion worth of mortgage backed securities. Overall QE1 can be classified as bailout fund.

In November 2010, Fed restarted its unconventional monetary policy, QE2, with $600 billion worth of long term treasuries buying plan. Fed expected to keep long term treasury rates and interest rates to be lower to speed start the economic activity. As previously announced, Fed concluded its $600 billion bond purchasing program in June 2011. QE2 can be termed as the fund used to kick-start the economic recovery.

In September 2011, Fed came up with yet another program called operation twist, wherein Fed started selling short term treasury bills and notes, and buying long term treasury bonds, to lower the long term treasury yields. Total fund allocated for this program was $400 billion. This showed that Bernanke was shifting the central bank's focus from repairing the damage from the subprime mortgage crisis to supporting lending in general.

In September 2012, Fed announced QE3. It agreed to buy $40 billion in MBS, and continue Operation Twist, adding a total $85 billion of liquidity a month. In December 2012, Fed announced it would buy a total of $85 billion of long-term treasuries and MBS put together. It clarified its direction by promising to keep it until one of two conditions was met: either unemployment rate to fall below 6.5% or inflation rose about 2.0%.

Did QEs Work?

In hindsight it’s always easy to analyze things! But talking about whether Fed’s QEs worked or not, it is somewhat complicated to question to answer and those answers are divided. But many economists agree that Fed accomplished couple of its goals. It’s unimaginable to know what would have happened without Fed's QEs. In the beginning, Fed wanted to stop the financial crisis from getting worse. By buying mortgage securities, Fed prevented more banks from failing and eased the frozen lending and money markets. Also being far more proactive and expansionary in nature of Fed as compared to ECB of European region reflects in the present status of both the regions. Fed helped to stabilize the U.S. economy, providing the funds and the confidence to pull out of the recession.

But whether QEs achieved what they were intended to achieve? Whether they succeeded in creating more jobs, spurring up the economy, boosting the inflation to Fed expectation level? I think answer would be “No”.  

Why QEs didn’t create enough jobs or reduce unemployment rate to Fed’s normal acceptance level of 5%. Why unemployment rate, which rose to 10% in 2009 till today didn’t reduced to before the crisis level of 5%, even after six non-stop years money pumping from Fed. Because monetary policies can't do much to reduce unemployment as liquidity is not the problem. In other words, there is little that expansionary monetary policies can do to increase the job creation.

High unemployment rate is due to two factors: cyclical unemployment and structural unemployment. Cyclical unemployment is caused by the economic downturns and structural unemployment happens when the long-term unemployed people lose their skills, needed to compete in the job market. Even now many economists argue that, present decline in unemployment rate is substantially because of long-term unemployed people quitting the job searching process, which is reducing unemployment rate.

QE didn't achieve Fed's goal of making more credit available and boosting the inflation. It gave the money to banks, which basically sat on the funds instead of lending it out. Though Fed succeeded in lowering the cost for banks to make mortgages, the banks didn’t actually start making more mortgages. Since banks didn't lend out the money, inflation wasn't created in consumer goods. As a result, Fed's measurement of inflation, the CPI, stayed below Fed's target.

However, QE did create an asset bubble kind of situation, first in gold and other commodities, and then in stocks.  An gold price more than doubled, rising from $869.75/ounce in 2008 to $1,895/ounce in 2011. Oil prices more than tripled from around $40/barrel in 2008 to around $120/barrel in 2011. After that, investors shifted to stocks. S&P 500 more than doubled from 700 levels in 2009 to 2000 levels in 2014.

QE could have been better designed. There could have been a better balancing act between monetary and fiscal policies. In retrospect far too much faith was put in the banks to channel the money to where it was needed. Edward Hadas of Reuters Breakingviews once nicely said, QE could have been worse, and it should have been better.

Will Fed’s QE taper talk topple Rupee again?

When U.S. Federal Reserve chairman Ben Bernanke spoke of reducing bond buying quantity (Presently Fed is buying $85 billion per month and the program is popularly known as QE, quantitative easing) first time in the month of May, markets were surprised and spooked.

U.S. Benchmark 10 year treasury yields jumped more than 100 basis points within a short duration, equity markets throughout the globe slumped, hot money from emerging markets started flowing out, developing countries’ currencies tanked and Indian Rupee was the worst performer of the league. Rupee touched historical all time low of about 69 per dollar in August from as high as 53 per dollar in May.

After continuous speculation in the markets, markets were prepared for QE tapering in September, but Fed took a cautious call not to taper and surprised markets again.

Following 2 successive months of Non Farm Payrolls jobs data around/above 200,000 and unemployment rate falling to 7%, there is again speculation of tapering in the markets. Timing and quantity of the tapering is a debatable question but will that talk of tapering cause volatility in forex markets again? Will Rupee again tank to such drastic level with such aggressive bearish bets.

I think, pace and level of volatility what we saw after Chairman Bernanke comments in May were too fast and too much and that may not repeat if tapering happens also. Obviously there will be some reversal in recent gains attained by Rupee as whenever U.S. sneezes rest of the world catches cold! So there may be slide in the level of Rupee but with not such aggressive pace and the level, seen earlier because of the following five reasons.

Priced in the market

Tapering news was new when Chairman Bernanke spoke about it in the month of May. After that various regional-Fed presidents either talked against it or in support of it. Markets participants started analysing for and against the tapering. Markets were prepared for tapering in September month’s Federal Reserve meeting itself. So this time whenever it happens or mere talk of tapering may not cause such drastic moves in Rupee markets as it is already priced in the markets that eventually tapering had to be done, it’s just a matter of time and quantity.

Bond yields

When Bernanke talked about it first time in May, Benchmark 10 year treasury yields were as low as 1.6% and now they are trading at 2.8%. Talking about Indian government 10 year bond yields, they were around 7.5% in May and now trading at around 9%. Both the countries yields are elevated levels indicating tighter liquidity scenario in coming months and looks like they are prepared for tapering.

Current account

Indian current account deficit (CAD), the difference between outflow and inflow of foreign exchange, was one of the worst among the emerging countries. But CAD reduced substantially over the last quarter. India's current account deficit narrowed sharply to $5.2 billion, or 1.2% of GDP, in the July-September quarter of 2013-14 on the back of turnaround in exports and decline in gold imports. Thanks to RBI and governments moves to curb the gold imports and improvement in exports helped by Rupee depreciation as well as recovery in global economy. The current account deficit was USD 21 billion, or 5 per cent of the GDP, in the second quarter of last fiscal. On Sequential basis also CAD improved from $26.9 billion in previous quarter.

Bottoming out of growth rate

India’s gross domestic production growth rate on decline from 2010 peak and it seems that it is bottoming out around 4.5% - 5% levels. GDP expanded 4.8% in the three months ended 30 September, compared with 4.4% in the preceding quarter. From last 4 quarters Indian GDP is hovering around 4.675% (4.8%, 4.4%, 4.8% 4.7% in reverse order) indicating the bottoming out of the Indian GDP growth rate.

Rajan effect

After Raghuram Rajan became RBI governor, markets showed confidence in his ability and credibility to curb the inflation, bond market reforms, clear communication with market participants and forward guidance. His strategy to attract Dollar deposits through FCNR route helped Rupee to regain some of the losses in the forex market. His shifting focus towards CPI inflation from WPI inflation is good for Indian economy in longer run, even though it may hurt in immediate future. After yesterday’s CPI inflation of around 11%, Rajan may increase repo rate by another 25 basis points in next week’s meeting, which indeed in turn helps Rupee as hot money will be chasing for high yields.

Raghuram Rajan’s balancing act of (im)possible trinity

When Raghuram Rajan took over the charge of the governorship of Reserve Bank of India (RBI), India was facing multiple issues. Because of Federal Reserve bond buying tapering speculation (at that time) hot money started flowing out of the emerging countries and India was no different. In addition to that India's unsustainable current account deficit (CAD) fuelled the bearish sentiment of the Rupee. It was the worst performer among the emerging countries currencies.

Meanwhile, then governor D. Subbarao hiked Marginal Standing Facility (MSF) by 200 basis points to prevent the currency outflow and so called excessive speculation. MSF is the rate at which banks borrow from the RBI in times of tight liquidity and it used to be 100 basis points above repo rate. Markets started speculating about RBI’s next possible move of capital controls, which Finance Minister and RBI governor denied repetitively.

Furthermore, India’s growth rate was (is) at its lowest pace in a decade. Inflation dilemma was continuing due to divergence between high level of CPI and moderate levels of WPI. Everybody was contemplating new governor’s stance on monetary policy at this crucial state of the economy.

Governor Rajan was supposed to prevent free fall of rupee, manage market expectation of not pursuing capital controls and have a monetary policy which is independent of all this. Which is impossible trinity and as name suggest it’s practically impossible to achieve all three at the same time.

In his first monetary policy meeting he took two important decisions.

1. Increasing repo rate by 25 basis points and decreasing MSF rates by 75 points. By doing this he took first step towards managing market expectations of not pursuing capital controls and at the same time he stressed upon the anchoring inflation and inflation expectations. By taking these steps he walked towards achieving two legs of the impossible trinity, i.e. free capital movement and independent monetary policy.

2. Providing the Dollar-Rupee swap facility for dollar funded deposits which helped India to attract nearly $12 billion in less than two months from then. This took care of Indian rupee depreciation and rupee recovered from its lowest levels. Third leg of the impossible trinity talks about fixed exchange rate, in which India doesn’t operate as Indian currency is partially pegged one.

Meanwhile, other factors like tapering postponement and Central government's efforts to curtail CAD also helped the market sentiments.

But credit must be given to governor Rajan as he is doing tricky job of balancing the impossible trinity of free capital flows, exchange rate (managed, not fixed in this case) and independent monetary policy, which is anchoring inflation.

Raghuram Rajan questions his peers’ policies!

Recently the Center for Financial Studies (CFS) awarded the Deutsche Bank Prize in Financial Economics 2013 to Raghuram Rajan. He presented his recent research paper on monetary response after the crisis.

He started his keynote lecture by saying “we seem to be in a situation where we are doomed to inflate bubbles elsewhere to boost the domestic demand” to question the low interest rate, “whether ultra low interest rates are part of the solution or part of the problem”. He called central bankers as “heroes” for rescuing the world from the brink of the collapse but warned his (now) counterparts, they may not be addressed same for the second half of the crisis i.e. recovery, as growth is not as expected!

He accepted the fact that he doesn’t have answers to the questions, he is raising, but he would like ask the questions!

He goes on to question the usage of monetary policy (over targeted fiscal policy) to drive the growth with the help of ultra low interest rates. He argues retirees as well as other people (who used to spend before the crisis) may not start spending in ultra low interest regime. In fact they may start saving more because spenders are under the water of debt over burden due to the crisis and retirees may not be able to get anticipated returns in these ultra low rates. Also he mentioned about “debt fuelled demand” is highly localised by quoting different spending patterns of Las Vegas and New York.

Moving on he questioned the credibility of the central bankers’ forward guidance like keeping interest rates low either time bound or conditional (like unemployment) dependent. Since recently markets started questioning the guarantee of central banks credibility and their talk.

He talked about amount of tapering may not alter much in long term Fed’s bond holding portfolio, which in turn should not have much impact on bond stock and flow.  But in reality it is not happening as per theory.

Talking about Bank of Japan, he hoped the balancing act of raising inflation expectation not too high and not too rapidly while maintaining bond yields low so bond portfolios don’t get beaten up, BOJ will succeed.

Unintended consequences of unconventional monetary policy

He said unconventional monetary policies may be intended to take more risk from entities like insurance companies and other financial corporation’s but he is not sure about that risk taking translates into real risk taking in real economy! But unintended consequences like spill-over and capital flow to emerging markets leading to asset price boom in those countries might raise the question. Politicians in emerging markets may forego the countercyclical policies during the capital inflow phase.

Even in industrial countries, monetary policy doing too much may take away the pressure from government and politicians and their focus. Because when central bankers say monetary policy is the only game in town they become the only game in town as everybody else then willing to wait. Damned if you do and damned if you don’t!

Pointing at taper talk confusions, he said we should plan our exit when we enter into something! Because of this stress he thinks emerging markets may decide not to run current account deficit, build safe structure by building reserves, focus on export led growth.

He said we need to break the cycle of one crisis to other like Asian crisis to Industrial world crisis and back to emerging market crisis again.

He ended his presentation by saying “I think I posed more questions than answers, but that’s the state of my thinking”.

Bond markets dictate Fed policy!

U.S. Federal Reserve chairman Ben Bernanke in his press conference after FOMC meeting on September 18 said “we can't let market expectations dictate our policy actions”, when asked about Fed tapering. But Federal Reserve did exactly let bond markets to dictate or reverse their policy guidance communication.

From last 4 months Fed wanted to prepare markets for the reduction in bond buying program. Various governors irrespective of their dovish or hawkish stance, they talked about either for or against tapering of bond buying. They communicated and convinced markets that Fed is expected to announce tapering of the bond buying in September meeting by $10 billion as per overall consensus in the markets.

When Fed started talking about tapering Benchmark bond yield started soaring and reached peak of 2.9% recently. Before tapering news hit the markets, Benchmark 10 year bond yields were around 1.6% in early May of this year. They jumped 130 basis points as heavy sell off in treasuries incurred. 30 year U.S. mortgage rates jumped to 4.2% from 2.8% around 50% jump! Markets started filtering in the news of Fed tapering.

After yesterday's FOMC meeting, in its press release, Fed said, “The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market.” In last 4 FOMC statements, Fed used almost same language “the committee sees the downside risk to the outlook of the economy”. Where as in this meeting it talked about concerns over financial tightening conditions in recent months!

In fact recent surge in bond yields is caused by Bernanke and his colleagues’ talk of tapering. They communicated their policy guidance as usually all central banks try to maintain the transparency in their policy guidance communication and their thought process.

Actually short term money markets eased in this span of 4-5 months. Below is the table in which all indicators indicate short term borrowing rates eased in all category.

Money market indicator	May 1, 2013	September 17, 2013	Change
2 week repo	0.17%	0.08%	-52%
3 month repo	0.16%	0.08%	-50%
2 week mortgage repo	0.21%	0.10%	-52%
3 month mortgage repo	0.20%	0.13%	-35%
Fed fund rate	0.15%	0.09%	-40%

Here question is not about whether economy started recovering or started creating enough jobs; it’s about how the world’s biggest central bank failed in judging economic scenario and failed in their communication. Many referred it as “surprise”, I would like to call it call as shocking. Surprises can be like Paul Volcker doubling Fed fund rates from 10% to 20% between 1979 and 1981 to tame the inflation. But not this one, where Fed prepared the markets for tapering and in turn markets convinced Fed not to taper!

Bernanke may be worried about Greenspan legacy!

According to various polls and forecasts U.S. Federal Reserve Chairman Ben Bernanke is expected to announce scaling back the monetary stimulus in the FOMC meeting (17th &18^th September). As per consensus Fed is expected to cut down its monthly bond buying program by $10 billion from present $85 billion (Fed is buying $45 billion government bonds and $40 billion mortgage securities per month to stimulate the economy).

When Bernanke spoke about tapering down of bond buying program first time in May, 2013 global markets reacted very sharply. U.S. bond yields soared, emerging countries’ bond, stock and currency markets sold off heavily and some counties' (Brazil and Indonesia) Central banks raised interest rates to prevent outflow. Aftermath of the global markets volatility, analysts started discussing timing and quantity of Fed tapering, whether American economy produced enough employment, whether economy recovered from the crisis, if yes then is this recovery sustainable?

But Bernanke may not be worried about timing (September or December) of tapering or quantity of tapering but the way markets are expecting and perceiving the quantitative easing (QE)! He may be worried about QE boosting asset prices than real economy going ahead. He may be worried about market expectations of low interest rate for too long. He may be worried about continuing his policies in his name after his exit from Fed Chair in January 2014. He may be worried about how history is going to see him, the one who saved the world from the great recession or the one who lead the world from the great recession to one more crisis!

Alan Greenspan, Bernanke’s predecessor lowered American interest rates after dot com bubble burst and 9/11 attack. Analysts criticise him for leaving interest rates too low for too long time, which was one of the reason for housing boom during early 2000. By the time Greenspan left Fed Chair (January 2006) American economy was at the edge of new crisis. Housing prices skyrocketed and it was too late for regulation and monitoring the situation as complex derivatives products dragged investments banks, insurance companies, banks, broking firms and rating agencies into the sector leading to economic crisis. So critics say Greenspan lead America from one crisis to another crisis!

Bernanke, whose term is ending in January 2014, may not want to repeat the Greenspan legacy! He may want to communicate to markets that stimulus shouldn't be taken for granted. He may be suggesting real economy benefitted sufficiently from quantitative easing or monetary stimulus has reached its limits to boost the economy and beyond this there might be bubble formation! He may want to leave the office with a note to historians stating that he started it (QEs) but he also tried to end it!

Raghuram Rajan: Governorship is not meant to win votes or Facebook “likes”!

Yesterday, 4^th September, Raghuram Rajan took the charge of Reserve Bank of India (RBI) governor’s role from outgoing D. Subbarao.  He started his first day with a bang, effectively communicating his priorities, by this he has taken care of recent criticism faced by RBI of not communicating clearly!

To begin with, he acknowledges the fact that “the economy faces challenges” and “these are not easy times” and at the same time he tried to calm the nerves by saying “India is a fundamentally sound economy with a bright future”.

Never say “Never”!

Rajan said “A central bank should never say “Never”!” meaning RBI is ready to take all possible options available on the table. Also he made it clear that RBI should emphasise on “transparency and predictability”. In these volatility times he wants “RBI should be a beacon of stability as to its objectives” so that markets should know what central banker is doing where it is going.

Monetary Policy

As reported earlier, RBI postponed previously set meeting on 18^th September to 20^th September. Rajan said he postponed it to “have enough time to consider all major developments in the required detail”,  indirectly he is saying he wants to take calculated move after watching policy guidance from United States Federal Reserve meeting scheduled on September 17-18.

He talked about “monetary stability” (different from “price stability”) to emphasize confidence in the Rupee. This is a welcome change in the RBI’s usual language of “price stability” and also “monetary stability” takes care of value of currency, inflation and source of inflation.

Inclusive Development

Rajan said “the RBI will shortly issue the necessary circular to completely free bank branching for domestic scheduled commercial banks in every part of the country. No longer will a well-run scheduled domestic commercial bank have to approach the RBI for permission to open a branch” to give importance to rural banking and small and medium scale industries’ funding.

He said Dr. Bimal Jalan will head a committee to screen the licence applications for new banking licences and hope to announce the licences within, or soon after January 2014. Further he said going ahead RBI will simplify the process of banking licences and banking domain entry.

He stressed about reduction of banks investment in government securities in a calibrated way, which will improve banks productivity and competitiveness.

He talked about foreign banks and their expansion plans but with certain regulations, so that RBI is not blindsided by international developments.

Financial Markets

Rajan talked about liberalising financial markets and restrictions on investment and position taking. So that investors take positions domestically and provide depth and profits to our economy than they take our markets to foreign shores.

He talked about increasing the permitted value of re-booking of cancelled forward exchange contracts for exporters and importers, developing domestic money markets and government securities and introducing interest rate futures on overnight interest rates.

Rupee internationalization and Capital Inflows

In Rajan’s words, “this might be a strange time to talk about rupee internationalization, but we have to think beyond the next few months. As our trade expands, we will push for more settlement in rupees. This will also mean that we will have to open up our financial markets more for those who receive rupees to invest it back in. We intend to continue the path of steady liberalisation. The RBI wants to help our banks bring in safe money to fund our current account deficit”.

Financial Infrastructure

To improve the reach, speed of flows as well as quality and quantity of lending he said strong financial infrastructure is need of the hour. He talked about using Adhaar, and information sharing between credit bureaus and rating agencies.

He talked about the cleaning up of banks balance sheets, bad loan problems and capital raising programs, which might face difficulties in a decelerating growth rate. He pressed for recovering loans, improving of the recovery system and related institutions.

Households

He announced Inflation Indexed Savings Certificates linked to the CPI New Index, to protect the households against CPI inflation. He said electronic bill payment system through bank accounts to “make payments anywhere anytime a reality” and mobile based payment, which can be a revolution if implemented successfully. RBI will facilitate for mini ATMs by non-bank entities.

In conclusion he said, “It involves considerable change, and change is risky. But as India develops, not changing is even riskier. Some of the actions I take will not be popular. The Governorship of the Central Bank is not meant to win one votes or Facebook “likes”. But I hope to do the right thing, no matter what the criticism, even while looking to learn from the criticism”.

Indian equity markets and rupee welcomed Rajan with a rally and brokerages have increased their target levels. Rajan started with a bang, but walking the talk is important now and his path (read my earlier post: Raghuram Rajan’s Trilemma) is not easy. 

Do policy makers have any other option?

After recent Federal Reserve meeting, when Chairman Ben Bernanke’s commented about tapering of bond buying program, global financial markets have become very volatile. U.S. benchmark 10 year treasury yields touched 2.8% recently from 1.6% in early May. Hot money started flowing out of emerging markets (EM) following some kind of theme like sell EMs and buy U.S.!

As a result of this majority of emerging countries’ stock and bonds sold-off, currencies started depreciating. Being part of globalized world now, India too is going through all these market phases. Apart from global issues, India has its own problems like large current account deficit, corruption and scandals, policy paralysis making it as non-favorable destination for investment at least for now. Indian growth, measured in terms of GDP, slowed to 5% levels from above 9% levels, Industrial Production data is not showing recovery signs, Consumer Inflation still very high and whole price inflation started inching up again; currency depreciated more than 12% in 12 weeks. 

Indian central bank, RBI is under pressure to support the growth, curtail depreciation of Rupee, monitor the capital flows and has to maintain its independence. RBI is exactly in “impossible trinity”.  

Consequently government and RBI took several measures to curb the currency depreciation and capital flight from India, like hiking gold import duty couple of time, banning importing of bullion coins and medallions, asking gold importers to keep 20% of total imported gold for exports and exports-purpose, domestic liquidity tightening, reducing the limit for Overseas Direct Investment (it’s like Indian FDI abroad) from 400% of the net worth to 100% and so on.

Many commentators are now criticizing these recent policy moves and intervention in market. It’s not the question of either supporting or opposing them, whether policy makers have any other option which will help them in near term? Of course there should not be any second thought on long term plans to correct the fundamentals; but what about immediate future as Keynes famously said “In the long run we are all dead”. 

This brings back the old question, whether markets are efficient or in other terms does efficient market hypothesis holds true? Going by Keynesian concepts and economic boom and bust cycles it does appear like markets need an invisible-hand to guide them and calm the nerves. But that again depends on how big that invisible-hand is, how far it is non-conventional in its approach and how much market is ready to listen to it and trust. Only time will tell!

Raghuram Rajan's Trilemma

Yesterday, 6th August, 2013 Prime Minister Manmohan Singh appointed Raghuram Rajan as next Reserve Bank of India's governor for 3 years. Rajan will take the charge from present RBI governor D. Subbaroa whose term is ending on September 4, 2013.

Rajan is taking charge at a crucial stage of economic cycle, where India's growth rate is at decade low, currency is depreciating, CPI denominated inflation is high even though wholesale and its core inflation is under RBI's comfort zone. Its like Rajan will be under the pressure of Trilemma (or also famously known as Impossible Trinity) wherein he has to manage currency, capital flows and independence of monetary policy. In theory it is considered to be impossible to achieve all three at the same time and this is what Raghuram Rajan will be facing!

In recent months capital is flowing out from the emerging countries after U.S. Federal Reserve officials started giving hint of tapering down of monetary stimulus know as Quantitative Easing. These capital outflows aggravated in India as economy was not growing at its potential, has current account deficit problem, government is in back-foot in decision making after series of corruption scams and etc. As a result of this Rupee is leading the depreciation pack in Asia and touching new lows.

To reduce the volatility in foreign exchange as it is claimed by central bank, RBI came into markets in intervals and started selling Dollars. Also took several decisions including liquidity tightening, making gold importing non-conducive and so called Open Market Operation. But it looked like RBI was forced to take certain steps as per its communication with markets and its participants. Which is third leg of Trilemma.

During same time RBI was facing growth concern issues as Indian economy was growing around 5 percent, slowest pace in decade and bottom was not sight! Wholesale inflation was just started reducing from couple of years' double digit mark, so RBI started reducing interest rates.

But thanks to capital outflows and Rupee depreciation, RBI (or forced to) jumped to forex management by tightening liquidity and asking public sector banks to sell dollars on its behalf.

Now RBI caught in between Rupee management, liquidity (or in other term capital flows) control, growth acceleration and getting back the credibility of the independence of monetary authority! Its now Raghuram Rajan trilemma!