The world is in an ironic situation. Last year, after the credit bubble burst, trillions of dollars were pumped to help the world recover from the worst financial crisis in 70 years. Now, that very same money may be causing the rise of new asset bubbles. The solutions of last year have very quickly become the problems or potential problems of next year.

The Fed at its monetary policy meet on November 4 had left the benchmark federal funds rate unchanged in the 0-0.25% range. It also stuck to its commitment to keep borrowing costs near zero for 'an extended period'.
Raghuram Rajan, PM's Economic Advisor and former Chief Economist of the International Monetary Fund feels the Fed's decision to persist with the current policy will create more asset bubbles. "The Fed will have to exit to offset asset price movement."
The US GDP grew 3.5-4% in Q3, which was hailed as the end of the recession by economists. They were also expecting the Fed to hike rates and end its earlier stimulus stance based on the positive data. However, those hopes were cut short with the Fed stating that the policy will remain unchanged until inflation stabilises and unemployment declines. But Rajan feels inflation will not be criteria for Fed's exit from stimulus. "The unimproved job scene would be a political constraint for the Fed."
No need for capital controls:
Huge liquidity inflows into the country aided by huge capital issuances, a healthy government borrowing programme, and demand for Indian equities has raised debates on whether the government will act to stem the rise in the rupee. In the past, the government has exercised capital controls to stop a runaway rupee. However, Rajan advises against such moves. He feels it is not the right time for capital controls. "Confidence in emerging markets has increased post the crisis. Liquidity Inflows into these markets are for the longer-term. India needs more capital for infrastructure growth."
On market reforms, Rajan says foreign mutual funds should be encouraged to enter India. "Foreign MFs can then invest Indian money in foreign equity."

Here is a verbatim transcript of the exclusive interview with Raghuram Rajan on CNBC-TV18. Also watch the accompanying video.

Q: What did you make of the strong gross domestic product (GDP) numbers coming out of the US, 3.5% for Q3?

A: I think 3.5% was widely expected – between 3.5% and 4%. What happened was that in the early part of the year, as we turned the year rather, we thought we were heading to depression 2.0 and companies were slashing inventories, we were getting a severe reaction to the financial crisis and to the impending doom and gloom of the world economy. That started reversing as all the measures – both the fiscal and monetary measures but also the bank bailouts took hold and so people said, “It is going to be a great recession not a great depression again”. As a result, since that time, the kind of inventory slashing that happened has moderated and the stimulus has started kicking in both of which have been very positive for growth.

Now in the US for example, we had the cash-for-clunkers deal, which contributed a big part of the growth in Q3 – more cars were produced because more cars were sold. The question of course is, are we going to, at this point, see some inventory rebound in the US. The rebound started in Asia, went through Europe, came to the US, going to continue for maybe a quarter or so. The problem is what happens after that because the stimulus is ramping up this year, next year it is flat or falling and in 2011 it falls off.

Once it starts falling off, it is subtracting from growth even though the stimulus is positive, it is going to subtract from growth at that point. The question of course is what is going to replace it. That to my mind is the central question amongst authorities around the world.

Is the consumer in the US for example going to come up and step back into his or her role when the stimulus wears off? And the answer there is that nobody really knows. Why? Two big factors, when does unemployment start leveling off, when does employment start picking up again? The signs right now are unclear. Most people think they are probably going to stick to 10% plus levels of unemployment through 2010 and it is only in 2011 that we are going to see some recovery.

If it looks like the previous two recoveries, it’s going to be a relatively jobless recovery for some time. That is going to be detrimental for growth, which means that when the stimulus wears off, the consumer is not going to pick up. The second factor in consumption in the US is credit. When the consumer wants to consume and is willing and is confident enough given the unemployment data, are the banks willing to provide the credit that they have been using to fuel the consumption.

Longer term we can’t rely on the US consumer. That was the problem we had this time. So, there is a fair amount of uncertainty outside of the next two-three quarters. I don’t think we are going to get a double dip unless we have a financial sector meltdown again, which I think is very low probability given the governments are pulling out all stops. I think we could get slow growth in industrial countries into the medium term, possible surprises of course. But I think that is the most likely scenario.
Continued on next page...