QE, which injected billions of dollars into the economy, provided a boost to the global economy and capital markets around the world. But what happened then was extraordinary, because mere talk of tapering QE by the Fed’s chairman resulted in disastrous effects on emerging economies.

This episode, which was dubbed the “taper tantrum”, generated turmoil in the Indonesian economy. There was a huge capital outflow, with foreign direct investment plunging from US$5.3 billion in the third quarter of 2013 to just $500 million in the fourth quarter of that year.

Over the same period, portfolio investment dropped from $7.6 billion to $3.3 billion. Exchange reserves fell from $108 billion to $93 billion. The rupiah depreciated by 20 percent against the US dollar. Economic growth slowed to 5.8 percent in 2013 after reaching a record 6.5 percent in 2011.

And now that the US economy is recovering strongly amid the pandemic, speculation that the Fed will taper off QE has begun to emerge. The market generally believes that the huge $1.9 trillion US fiscal stimulus and President Joe Biden’s proposed spending on infrastructure would spur rapid economic recovery and overheating. As inflation rises and the labor market tightens, the market doubts that the Fed would maintain its current loose monetary policy, and many believe that at a certain point, the Fed would tighten its policies by raising the benchmark rate and unwinding its asset purchases. These kinds of uncertainties have triggered market volatility recently.

According to Bank Indonesia (BI) there was a capital outflow of $1.6 billion in the first two weeks of March, after a surplus of $7.1 billion in the previous two months. The Jakarta Composite Index (JCI) was down 4.1 percent, and the rupiah depreciated by 3.5 percent against the green back. 

In its April policy meeting, the Fed reiterated that it was not in a hurry to buckle up. It would wait for policy changes to be warranted.

But there have been fears in the market that the expected surge in American economic activity could fan inflation and force the Fed to step back from its loose monetary policies.

According to Fed chairman Jerome Powell the expected spike in inflation would be temporary owing to last year’s low base of comparison and is not likely to require policy action. He said that an episode of one-time price increases as the economy reopened would not be the same as persistently higher year-on-year inflation. And so it is not yet time to start talking about tapering the Fed’s vast bond buying programs.

But the market has different opinions and believes this time inflation matters more than usual because of the amount economic uncertainty.

The relaxation of social distancing, President Biden’s enormous $1.9 trillion economic stimulus, and the proposed $2 trillion infrastructure spending will all make the difference.

Larry Summer, a prominent American economist and Olivier Blanchard, a former chief economist of the IMF, predicted that the US economy would face overheating and that it would be wrong to dismiss the rise in inflation as a mere mathematical quirk. The US economy is recovering rapidly from the downturn triggering an increase in inflation to 2.6 percent in March, year on year, up from 1.7 percent in February, driven by price increases for food, energy and services.

Market analysts predicted that in June, America would achieve herd immunity, full employment and inflation at 3.5 percent. This would force the Fed to start talking about tapering its QE programs.

But whether the market is right or wrong in its prediction about the Fed’s future policies, the Indonesian government has to watch the developments closely and take steps to mitigate the impact if a taper tantrum materializes.

In response to the 2013 taper tantrum, BI implemented policy rate hikes and intervened in the foreign exchange market, while the government tightened its spending, particularly by reducing subsidies.

The government response apparently worked, as the rupiah quickly appreciated, stock market indices rallied and 10-year government bond yields fell from 8.9 percent to 7.8 percent.

But now the government does not have the luxury of implementing the same response if a tantrum-like situation arises. Things are now quite different. In 2013, the Indonesian economy was still growing, while now the economy is contracting in the wake of the pandemic. If in 2013 the government could still afford the cost of policy tightening, now a slight policy tightening could destabilize the economy and generate turmoil in capital markets.

But regardless who is right in their inflation projection – whether it is the Fed or the market analysts and the economists – it is imperative for BI and the Finance Ministry to anticipate market volatility by strengthening macroprudential policies to mitigate the severe impacts of a taper tantrum-like episode.

Their decision to extend the burden sharing scheme to Dec. 31 of this year from the original end date of December of last year was the right decision in the face of the uncertainties ahead. BI intervention in the government bond market has not only eased government deficit financing but has also helped stabilize government bond yields.

Amid these uncertainties, market confidence in BI’s credibility is crucial, and this will depend on BI’s skill in communicating its policies to the market. The market’s perception of BI’s policy pronouncements will be priced into the market valuation and rupiah exchange rates.

Ultimately, it will impact the space of the Indonesian economic recovery.

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The writer is an economist and a commissioner of a publicly listed company.