By V Thiagarajan Nobel laureate Paul Romer writes that “For more than three decades, macroeconomics has gone backwards.” He sees economists no longer being concerned with whether or not their predictive models have any practical relevance and says we have entered an era of “post-real” macroeconomics. He has been proved right beyond any doubt. According to most […]
By V Thiagarajan
Nobel laureate Paul Romer writes that “For more than three decades, macroeconomics has gone backwards.” He sees economists no longer being concerned with whether or not their predictive models have any practical relevance and says we have entered an era of “post-real” macroeconomics. He has been proved right beyond any doubt.
According to most economists, the year 2022 was supposed to be the year of a revival of economic growth. However, it is turning out to be a period of geopolitical risks, persistent supply chain disruptions and financial market volatility, all of which are playing out in the context of surging inflation, which was dismissed by the same macroeconomic forecasters as transitory not too long ago.
Firstly, more than a decade of easy money and low inflation convinced the new generation of central bankers that there were no costs to their aggressively accommodative policy. The cheap cost, abundant liquidity unleashed by them had pushed the financial assets as well as real estate to their historic highs.
These bubbles had now become too big and have proved to be the root cause of the high inflation that is being experienced now. The normalisation of these monetary policies is being seen as the only solution to resolving this menace. However, the problem with unconventional monetary policy is that — because bad shocks come along with regularity — it’s never a good time to normalise.
Monetary Governance
Central banks are trying to pretend that they are part of the solution although it is ironic that they had only created this problem in the first place. Regardless of what central bankers do going forward, the reality is that the confidence in monetary governance is currently at its lowest ebb.
The global monetary system is currently facing historic challenges and most of the central banks around the world are caught between the devil and the deep sea: Hit the brakes too hard and risk a recession by bursting these bubbles or tap the brakes in a stop-go pattern and risk having inflation well into 2023 and beyond. This challenging task is being made more daunting by forces outside their control.
Aside from the pandemic-related base and one-off effects, the price surge is largely due to the combination of a strong re-opening momentum and snarled-up supply chains as the fragile global production and distribution system failed to keep up with the post-pandemic demand.
The Ukraine crisis has further exacerbated inflation dynamics, driven above all by a sharp increase in commodity prices — notably for energy and food. More recently, China’s zero-Covid policy and the related lockdowns have put additional strain on supply chains which threatens to keep producer prices higher for longer.
In periods of complacency, the world’s central banks play at mimicking the Fed without having the world’s reserve currency or the legal security and financial balance of the US
As the war in Ukraine drags on and eradicating the Covid virus becomes an ever more elusive goal, the implications of the rising cost of living are far-reaching and raise hard questions about the adequacy of commonly used inflation models and in turn policy choices derived from these.
Behind the Curve
In periods of complacency, the world’s central banks play at mimicking the Fed without having the world’s reserve currency or the legal security and financial balance of the US. When the Fed stops the music, other central banks prefer to initially talk down the rub-off impact and thereafter try to catch up when the crisis reaches their shores.
Central banks all over the world have been on a hiking spree of late after having remained mute spectators for long — there have been more than 60 rate hikes in the last two months by the central banks all over the world. Hence the popular narrative: Central banks are behind the curve.
The rate hikes are supersized as central banks want to catch up with reality. The US now leads the charge for potentially the largest and fastest tightening of global monetary policy in decades
To better understand the concept of being behind the curve, consider an analogy of a driver driving a car on a road that bends sharply to the right. If the driver dozes off for a moment, he might not turn the wheel until the car is in the curve. Even if the steering wheel is eventually turned to the right, if the adjustment occurs too slowly, the car might end up falling on the left.
Monetary policy too works on similar lines. During periods of rising inflation, if the central bank raises its target rate too slowly, and thus short-term interest rates fall below the (rising) equilibrium interest rate, then the monetary policy becomes effectively more expansionary despite modestly higher interest rates. In that case, the slow-reacting central bank is said to be behind the curve and hence there is a risk of a serious policy error.
As most of the central banks have fallen behind the curve, they are currently taking remedial measures at a hastened pace — largely in the dark. The rate hikes are supersized as they want to catch up with reality. The US now leads the charge for potentially the largest and fastest tightening of global monetary policy in decades. It’s like letting the asking rate go sky high before the batting team goes berserk and risks losing the game.
Unfortunately, no one knows just how high the central banks’ short-term rate must go to restrain inflation. The liquidity taps also are set to go dry — the estimates are that policymakers in the G7 countries will shrink their balance sheets by about $410 billion in the rest of the year. It’s a stark turnaround from last year when they added $2.8 trillion — taking the total expansion to more than $8 trillion since the onset of the pandemic.
Although the common belief is that the equity markets reflect the state of the economy, it is always the bond markets which have a fairly strong track record of predicting the future economy. One of the unique aspects of this cycle has been the simultaneous declines in both stocks and bonds. As of now, the interpretation of the price action in the global bond markets is that the global rates can stay elevated for long.
How High Rates Can Go
Financial markets are starting to reflect a growth-scare environment as financial conditions have tightened substantially. The journey from easy to tight monetary policy was a fast one, and certainly took markets by surprise — just a few months ago the Fed itself was forecasting only three increases in the federal funds rate (interest commercial banks charge when they lend money to one another overnight).
The risk remains that the Fed is forced to become even more aggressive if inflation fails to come in line
A 50 bps rate hike and the start of balance sheet runoff occurring simultaneously would have been nearly unthinkable in the 2010s. But, today’s economy is much different from the one that prevailed in the previous decade. The balance-sheet reduction will be roughly equivalent to three quarter-point increases through next year. When added to the expected rate hikes, that would translate into about 4 percentage points of tightening through 2023.
The risk remains that the Fed is forced to become even more aggressive if inflation fails to come in line. The next 12 months are going to feel like a very long decade. While it is easy to draw up a path to a soft landing, believing that it can be accomplished despite an inflation shock and central bank tightening takes an enormous leap of faith.
It is crystal clear that the Fed wants to get to a neutral federal funds rate as quickly as possible, and then assess how far beyond that neutral rate is necessary to tame inflation.
Such a dramatic step-up in borrowing costs in the midst of large Federal issuances naturally calls for higher rates for a longer time. It is obvious that interest rates may not pull back meaningfully until the end of the Fed’s rate hikes are within sight.
The sanguine view that inflation will decline significantly on its own, and that the Fed will, therefore, not have to raise interest rates too much, is looking more suspect by the day. With savings having soared during the pandemic, the more likely scenario is that consumer demand will remain strong, while supply chain problems become even worse resulting in the continued upswing in prices.
Fed’s actions cannot do much to directly relieve inflation related to supply chain pressure, but a tighter policy environment could slow broader activity and allow producers to catch up. Federal Reserve Chairman Jerome Powell will draw inspiration from the experience of the mid-1990s, when Alan Greenspan was able to raise rates, tame inflation, and navigate to a still-positive growth path for the US economy. This time, the Fed does not have a demographic or globalisation tailwind and is starting the tightening cycle well behind the inflation curve. While it is possible the experience of the mid-1990s could recur, the degree of difficulty is much higher today.
Closer Home
The Reserve Bank of India has followed the global monetary policy cycle since the pandemic and tried to emulate the Fed by passing off the initial spurt in inflation as transitory. Then there came a late shift in RBI’s focus from ‘reviving and supporting growth on a durable basis’ to ‘withdrawing accommodation to curtail inflationary pressures’ — acceptance of staying behind the curve.
If RBI’s post-lunch May 4, 2022 template is set to be followed in future as well, there is a distinct probability that RBI could keep pace with Fed rate hikes over the course of this cycle
In an off-cycle move, the RBI stunned the markets last time by hiking the repo rate by 40 bps to 4.40% and increasing the CRR by 50 bps to 4.50%. The significance of the timing of the surprise tightening both on the rate front and liquidity front is not lost on the markets. The Fed was to announce its decision later in the day and it underlines the urgency of the RBI to stay in tandem with the global monetary policy cycle despite the pressing need to stay accommodative to steer the massive government borrowing programme.
If their post-lunch May 4, 2022 template is set to be followed in future as well, there is a distinct probability that the RBI could keep pace with the Fed rate hikes over the course of this cycle
Shun Conventional Wisdom
Beware of conventional wisdom, especially when it comes to the financial markets. In 1999, it was “tech stocks can’t miss.” In 2006, it was “home prices never go down.” Now it’s “bond yields can’t rise because governments can’t afford it” and “equities can’t go down as central banks can’t afford”.
This cycle is unique in nature and no amount of historical evidence can be used to measure where the interest rates can top and when inflation can ease. If we observe the history of inflationary periods, we can conclude that prevailing economic regimes reach their apotheosis, and then change, when the extreme conditions they have created lead to permanent policy change. However, the regime changes in frequent episodes. In Jan 1970, one episode of inflation ended with a peak Fed rate of around 6%. While the markets thought the inflation had ended, there have been multiple episodes which heralded an inflationary regime which continued till the early 1980s.
No amount of historical evidence can be used to measure where the interest rates can top and when inflation can ease. An episode is different from a regime
It is highly likely that the global economy is in a similar place today: the first battle is over, but the war has just begun. It would be prudent to stay prepared for higher rates as the central banks themselves are not aware as they are hiking in the dark.
In these circumstances, it would be prudent to keep portfolio risk to levels no higher than strategic asset allocations, remain diversified (across and within asset classes), focus on high quality fundamentals, and utilise periodic rebalancing to take advantage of volatility by “adding low and trimming high.”
(The author is an Independent Market Expert)