News in Charts: QE no panacea for EMs in another Taper Tantrum

Since the Great Financial Crisis, inflation has been quiescent across the developed world, despite some initial fears about Quantitative Easing’s (QE) impact. In fact, developed central banks have struggled to raise inflation to their targets. Against this backdrop, doubts have built about their ability to generate inflation, and many economists have argued that the high inflation of the 1970s was the exception rather than the rule.

Inflation fell sharply during the early stages of the Covid-19 pandemic, with the US Personal Consumption Expenditure measure troughing at 0.5% on a twelve-month basis in April 2020, before recovering to 1.3% at present. Many economists expect it to rise further over coming quarters helped by higher energy prices. Initially, investors in fixed income markets viewed the pandemic as overwhelmingly deflationary, at times pricing in sub-1% US CPI inflation on average over the next five years (chart below). We were always sceptical that this was the correct response, and indeed have been warning our clients since 2020 Q3 of a meaningful upside risk to inflation as substantial household savings balances, a consequence of generous fiscal support packages in the major economies, are at least partly unwound. Investors have since moved towards our way of thinking, with market-implied measures of expected inflation moving rapidly back towards target.

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Taper Tantrum II?

If there were an unwelcome spike in inflation, there is a risk that the Fed may have to rein in some of its policy accommodation – and/or financial markets may abruptly discount a higher risk premium on government bonds and other financial assets. A template for what may transpire was provided by the 2013 “Taper Tantrum”, where the discussion of a potential tapering of QE by Fed chairman Ben Bernanke fuelled a sharp rise in US Treasury yields and a massive sell-off in emerging market (EM) assets. Countries with large external vulnerabilities and fiscal problems were particularly exposed. The so-called “Fragile Five” (Brazil, India, Indonesia, South Africa and Turkey) saw sharp falls in asset prices and exchange rates between 22 May and the end of August 2013.[1]

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In a report shared with clients last week, we used our proprietary Fathom Financial Vulnerability Indicator (FVI) to attempt to highlight EMs most at risk if such a scenario were to materialise again. It suggested that Tunisia, Kenya, India, Romania, Pakistan and Egypt could be particularly vulnerable (FVI Monthly Update).  We intend to conduct a broader analysis soon of the strength of various countries’ defences and some of the potential tools at their disposal.

EM QE, unlikely to be a panacea

One tool that has recently become part of the monetary policy arsenal of some EMs is QE. During the Covid financial panic, around 15 EMs unleashed QE for the first time. The purchases were generally on a much smaller scale than those of central banks in developed economies, which is largely reflected in the smaller growth in their balance sheets (chart below), whilst an often-stated aim was to improve market functioning.[2] Initial results were positive, with QE announcements typically lowering government bond yields (second chart below) without triggering major FX depreciations.[3]

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Some investors have wondered about the potential for EMs to employ QE more regularly in the future, perhaps in the event of major market disruptions such as another Taper Tantrum. In our opinion, the future effects might not be quite so benign. First, we doubt QE can be successfully adopted more broadly across EMs. Those recently adopting it were the ones with the most credible policy frameworks and likely judged that the market reaction would be favourable – particularly since their actions seemed relatively measured compared with the Fed and other developed central banks. For countries with less credible policy frameworks, the financial market reaction would likely not have been so positive. Second, we suspect that even those who recently began QE may not get such a favourable market reaction if they engage in additional asset purchases in ‘normal times’, or if the Fed’s actions or the markets’ reaction to adverse US inflation developments were causing a major global risk-off environment. Longer term, we are also cautious about the political economy risks with EM QE – amid a much greater chance of fiscal dominance than in the developed world.

[1] see IMF (2014), ‘Emerging market volatility: lessons from the taper tantrum’, IMF Staff Discussion Note.

[2] see IMF (2020), Financial Stability Report, November 2020.

[3] see BIS (2020), ‘Central bank bond purchases in emerging market economies’, BIS Bulletin No. 20. and IMF (2020), Financial Stability Report, November 2020.

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