QE3 could push inflation in emerging markets

There has been a lot of talk and discussion about whether or not the Fed is going to implement a QE3 after the second round has recently concluded with no real progress made in the economy. Another round would have numerous impacts and not just on the US, but on a global level as well.

Vikas Agarwal, ET Bureau
Jul 24, 2011, 07.18am IST
The Economic Times

These days, there is a lot of talk and speculation on the possibility of another round of quantitative easing in the US - QE3. The Federal Reserve has already implemented two rounds of quantitative easing (financial stimulus) to bring the economy back on track after the 2008-09 recession. The second round of quantitative easing (QE2) worth USD 600 billion concluded last month. There are speculations in the markets that the current situation of a slow economic recovery, slow rate of new job creation and overall fragile economic growth in the US may lead to another round of quantitative easing - QE3.

With this round of quantitative easing, the Federal Reserve will look at providing extended assistance and stimulus for economic activity in the US by keeping the interest yields on bonds low, and thereby forcing investors to invest in riskier assets such as equity . The idea is that these investments in the economy will in turn create a wealth effect and result in more consumers spends. This will increase the wheel speed of the US economy.

At present, there are many counter arguments and debates going on as the previous rounds of QE did not deliver the results up to expected levels. Analysts believe another round of a large QE package can impact the markets in more ways than one, and therefore investors should track the developments around this issue.

These are some of the expected results globally in case the Fed goes ahead with QE3:

Impact on dollar

The dollar is expected to weaken against major world currencies. The Fed will expect a weaker dollar to have a positive impact on the current trade imbalances. However, the cross currency movements will depend on several other global factors too such as developments around the sovereign debt crisis in Europe.

Impact on global inflation

The QE3 is expected to increase liquidity in the markets. It can, hence, aggravate the inflation rate further. The inflation rate is manageable in the developed countries due to slow the economic activity. However, it will hurt emerging markets like India which are already facing a high rate of inflation.

Impact on commodities

The prices of global commodities went up quite a bit during the last QE phases. The main reasons for the price rise include risk aversion , weakness in the US dollar and sharp cross currency movements.

The commodity prices have corrected over the last couple of months as the QE2 effect faded off. Analysts believe another round of quantitative easing will trigger another cycle of high commodity prices in the global markets. In fact, there have already been some in global commodities over the last few days over speculations on the QE3 package announcement.

Impact on domestic markets

Broadly, QE3 will be good news for emerging markets including India. The QE will increase inflow of funds to emerging markets from foreign institutional investors. The fund inflows here have slowed down considerably since the beginning of this year due to signs of economic recovery in the developed countries.

Analysts believe a part of this excess cash (generated as a result of QE3) will be channelled to emerging markets as these countries are better-positioned in terms of economic growth. In the domestic markets, the foreign institutional investor funds are expected to remain strong in the short to medium terms. This will keep the markets in a bullish momentum. On the flip side, this will mean challenges related to high liquidity and the high inflation rate will persist.

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