Federal Reserve officials decided Wednesday to start gradually reducing their massive economic stimulus program. Beginning in January, the Fed will buy $75 billion in bonds each month, down from the $85 billion it had been buying since September 2012.

 

“In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases,” the Fed said in a statement. The Fed decided to cut back on both types of bond purchases -- mortgage-backed securities and Treasuries -- by $5 billion per month each.The bond-buying program has become so large, it’s expected to push the Fed’s assets to $4 trillion this week -- money the Fed basically created out of thin air. The new cut represents the beginning of a gradual wind-down process which Wall Street has nicknamed “tapering.”

 

But the complete end to Fed stimulus is still probably years away. Fed officials have been stressing lately that tapering does not mean “tightening.” In fact, the Fed extended its commitment to keep short-term interest rates “exceptionally low” until either the unemployment rate falls to around 6.5% or the inflation rate exceeds 2.5% a year. At a press conference immediately following the announcement, Bernanke stressed that the Fed’s actions did not amount to a withdrawal of support for the economy. “Nothing we did today was intended to reduce accommodation,” he said. Most officials expect rates to rise in 2015, despite the fact that inflation will likely still be below the target at that point.

 

Bernanke also explained that the Fed had “enhanced” its forward guidance on keeping interest rates low.

 

“The committee is determined to avoid inflation that is too low, as well as inflation that is too high,” Bernanke said. But rates will remain low for a while, so consumers can still expect to lock in historically cheap rates on mortgages, car or business loans, albeit probably not at the record lows seen earlier this year. Stocks jumped following the announcement, with the Dow gaining 200 points after the news.

 

Traditionally, the Fed has used low interest rates to stimulate the economy in times of stress, but in the most recent financial crisis, it was forced to take unprecedented measures. First, the Fed slashed its key interest rate to near-zero in 2008. Next, in a program known as “quantitative easing,” or QE, the Fed started buying bonds like U.S. Treasuries and mortgage-backed securities in an attempt to lower long-term interest rates too. That second move came in three rounds that have since been nicknamed QE1, QE2 and QE3. Among them, QE3 was the only program that wasn’t given an explicit end-date. Instead, the Fed said it was looking for substantial improvement in the job market.

 

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Little Impact on Nepal

In mid-2013 talks about the Fed’s QE tapering had impacted Nepal while rattling the world markets. The US dollar soared to record high levels following Fed’s indication that it will eventually put an end to the flow of cheap money in coming months. Nepal’s economy, which is considered more insulated to international events (due to non-integration in the global market) also suffered from this. Nepali Rupee, which maintains exchange rate-peg with the Indian Rupee, was hardest hit by the QE taper woes. The weakening of INR caused Nepali Rupee to slide historically against the US dollar. The devaluation mainly contributed to Nepal’s fast rising inflation rate and prices of imported good in the local market. The sharp devaluation of NPR initiated a debate, whether NPR should continue its exchange rate-peg with INR. 

 

However, the scenario after the Fed’s latest decision looks different compared to the mid-2013. Experts say that QE tapering might have little or no impact on Nepali economy. “Compared to the scenario in May-June, Nepali economy is in more comfortable place,” says Krishna Bahadur Manandhar, former Governor of Nepal Rastra Bank. According to him, the global financial markets seem to have adjusted their fears on QE tapering. The depreciation of Nepali rupee was caused by devaluation of INR against the US dollar. Problems within the Indian economy such as the widening current account deficit (CAD) and trade deficit were blamed as the main factors for currency weakening. Despite various obstacles, India has effectively managed to overcome these problems in recent months. “With measures like hike in gold import duties, India has narrowed CAD and trade deficit,” Manandhar said adding, “India’s forex reserve has also risen significantly in past seven months.” He opines that these developments help to check the currency devaluation and spillover effects of Indian economy.