The U.S. Federal Reserve's gradual exit from so-called quantitative easing (QE) — open-ended purchases of long-term assets — has financial markets and policymakers worried, with warnings of capital flight from developing economies and collapsing asset prices dominating policy discussions worldwide. But given that most major economies operate under a flexible exchange-rate regime, these concerns are largely unwarranted.
The logic behind the fear of the Fed's "tapering" of QE is straightforward. Unconventional monetary policy in the United States — and in other advanced countries, particularly the United Kingdom and Japan — drove down domestic interest rates, while flooding international financial markets with liquidity.
In search of higher yields, investors took that liquidity — largely in the form of short-term speculative capital ("hot" money) — to emerging markets, putting upward pressure on their exchange rates and fueling the risk of asset bubbles. Thus the Fed's withdrawal from QE would be accompanied by a capital-flow reversal, increasing borrowing costs and hampering GDP growth.