"When US sneezes, world catches a cold...": Why Uday Kotak fears another 'taper tantrum'

Like all other parts of the world, the United States also reported supply chain disruptions due to unprecedented lockdown and halt in economic activity. This led to higher input prices and subsequently, higher consumer prices. Therefore, throughout 2021, the Fed maintained that inflation is transitory and would decline once the supply chain irregularities are fixed.

However, recently, there has been a realisation that this inflation may be here to stay as it is not just driven by the supply side but also by the demand side. How? Well, the US, like many other nations, witnessed rapid recovery in economic activities after the lockdown lull. This meant that households received more disposable income. As people are still not willing to spend on services like travel, hospitality, entertainment and restaurants due to the pandemic, they purchased goods. This led to a spike in demand and the pandemic-hit supply chains could not keep up, leading to higher prices of commodities.

Now, a rise in inflation in the US has a domino effect. For instance, when prices of commodities rise in the US, the cost of raw materials and other imported goods rises for India as well. Given today's globalised economy, India and other nations are feeling the heat of rising inflation in the US. As inflation touched 7 percent in the US in December 2021, India too recorded an inflation figure of 5.59 percent.

'Taper Tantrum'

After the 2008 financial recession, the Federal Reserve started large purchases of bonds and other securities. This, in theory, helped the nation increase liquidity in the financial sector and encourage economic growth.

However, the Fed went overboard with its bond purchase strategy. It tripled the size of its balance sheet -- from around $1 trillion to around $3 trillion -- by purchasing almost $2 trillion in treasury bonds, stoking fears of hyperinflation. As economists have always said, there are unavoidable consequences when the Fed Reserve feeds the economy for "too long".

After realising that its bond purchase policy may lead to a prolonged period of high inflation, the Fed started tapering -- or cutting down bond purchases. This led to another issue as by this time (around 2013), investors had become dependent on the massive Fed support for asset prices through its ongoing bond purchases.

Expectantly, a sudden decline in bond purchases by the Fed -- which had become one of the world's biggest buyers -- shocked the investors. In response, panic-hit investors started selling bonds. This event is referred to as the 'taper tantrum' in the financial world.

As investor behavior is based on current conditions and expectations of future Fed policy, if the US central bank again resorts to tapering, as Uday Kotak fears, panic can ensue because investors, who have become dependent on bond purchases, will fear that the lack of Fed support would trigger market instability.

And in a world of interconnected economies, what happens in the US doesn't just stay in the US