Explained: Fed tapering and why market is worried about it

The minutes of the July FOMC meeting showed most committee members believe it is time to reduce asset purchases. Global financial markets hadn't taken the news in stride -- bond yields had hardened and stock markets had corrected.

But why is the market worried? To understand this, we need to go back to basics.

Central banks buy government securities (also called bonds) and infuse money into the economy via open market operations (OMO). Currently, the Federal Reserve -- the central bank of the United States and the most influential economic institution of the world -- buys securities worth $120 billion.

While in March 2020, Fed had assets worth nearly $5 trillion, the number as of April 2021 was approximately $8 trillion.

To keep interest rates low and encourage individuals and businesses to borrow.  Through the bond purchases, what the Fed is essentially doing is handing cash to banks and increasing the money supply in the system.

When money is freely available, the cost of money--measured by the interest rate--falls.

Tapering means a gradual slowdown of the Fed's large-scale asset purchases. The central bank wants to reduce the supply of money from the economy as inflation has now risen to multi-year highs.

When inflation is high, one of the immediate steps any central bank takes is to reduce the money flow in the system.  Fed wants to slowly remove the monetary stimulus it extended when the economy slumped after the outbreak of coronavirus and resulting lockdowns.

The first time Federal Reserve had decided to taper its bond purchases was after the impacts of 2007's global financial crisis subsided.

The US economy had recovered by 2010 and the Fed had begun considering hardening the monetary policy by the end of 2013. However, at the time, global investors had no idea of the Fed's decision.

The then Fed Chief Ben Bernanke had suddenly said, "we could in the next few meetings ... take a set down in our pace of purchases."

Caught off-guard, the indices on Wall Street had collapsed immediately, bond yields had surged, and the currency market went haywire -- the notorious taper tantrum of 2013.

The interest rate in the US is critical for global markets due to the asset-buying frenzy fuelled by near-zero interest rates. Almost half of the global funds moved to the US markets to take advantage of ultra-low rates. These investors had borrowed money in dollars to invest in assets globally. Now they will have to sell back these assets to pay their loans. This de-leveraging can disturb the markets.

This will also affect India's foreign portfolio inflows. Earlier when the Fed had announced tapering in 2013, FPI inflows to India had shrunk from between 2015-18. In fact, experts say the inflows worth nearly Rs 2 lakh crores in 2020 were due to interest rates in the US being near zero.

During the taper tantrum of 2013, India suffered a double whammy. Equity prices collapsed as foreign institutional investors pulled out money from stocks and this also caused the rupee to depreciate sharply.

At that time, domestic inflows were not strong enough to be able to cushion the impact of selling by foreign institutional investors.

Today, the Indian market is on a much better footing, thanks to strong inflows from retail investors--through direct investment in stocks as well as through mutual funds.

Still, if the mood in global markets changes for the worse, Indian markets will feel the heat in the short term.