I get a sense that the Greenspan put is past its expiry date: Prof Jayanth Varma

According to Prof Jayanth R Varma, the Fed will do aggressive rate hikes through 2022-2023.

In this second part of an interview with Prof Jayanth R Varma, external member of the central bank’s Monetary Policy Committee, he talks about inflation in developed countries, what influences rate-hike decisions there and why the Greenspan put may finally need to go.

In developed countries, like in the US, the gap between inflation and interest rates is the widest historically… at least, in the last 40 years. In the short term, we see this reflected in the sharp rise in bond yields. Yields for US 10-year bonds have really gone up sharply though they are still under 3%. What does this gap mean for market expectations and asset class returns?

Yes, it's true for the US, Europe and Japan.

There, there is much greater concern how far the central bank would actually be able to tighten interest rates without provoking a significant recession. The developed world is actually somewhere at the bottom after 30 years or more of declining yields. After the early 1980s, after the Volcker Shock (when the Fed chairman Paul Volcker raised rates to 20% to tackle high levels of inflation at 10%), the rates have been on an almost secular decline for 30 years now.

That very long, super-cycle of bond yields now seems to be turning. While the market does expect the central bank to do some tightening, it also worries that if the Fed tightens too much, the price in terms of the recession or whatever could be sufficiently strong that the Fed would be forced to pause (on the rate hikes).

There is even a segment of the market that believes that the Fed might have to reverse the hikes because the economic outcomes could be unpalatable. That causes the yield curve to flirt with inversion… a segment (of the curve) around one to two years goes up believing that the Fed will follow through with the hikes but, in the longer term, at the 10-year-segment, they believe this (rate hikes) can’t last.

There is also a great deal of fear that what is happening in Ukraine is a severe shock to the economic growth, particularly in the developed world. Therefore, the Fed would not be able to raise rates too much. And that's even more true about the ECB (European Central Bank), where economic growth is a lot more fragile than it is in the US.

In emerging markets, by and large, they are looking at a normal business cycle. The pandemic was a big growth shock, we are coming out of that. The interest rates just need to normalise. We don’t see growth going back to 8-9%, but 7% growth will happen.

At EM (emerging markets), we tighten the way we are accustomed to. The AE (advanced economies) world is scared that they're looking at something that they haven't seen in a long time. They don't know what to make out of it.

Also read: Central banks seem to have been slow in their response

In the US, there is a lot of push-and-pull on rate hikes. How much do you think that the Fed may be able to do in the next one year?

(Laughs) I think running monetary policy for India is difficult, trying to do that for the US is very different. In the short term, I would see significant tightening because the Fed has given far too many clear signals that they're going to be aggressive. The question is how long can they sustain that. In 2023-2024, will the Fed be forced to pause (the rate hikes) or revise (their stand)? That is the concern. But, for 2022-2023, I would think that the Fed will do aggressive rate hikes… that is the message coming from virtually all the members there.

You said we are in a super cycle of sorts in bond yields. If this super cycle is reversing, will this lay the foundation for long periods of low returns in equity markets?

The bond market is basically an inflation story, but the equity market is as much a growth story as an interest-rate story. If the economy grows, then the equity market can take a lot of interest rate hikes in its stride. If earnings are growing and you say that I have to discount earnings with higher rates, then I would say that the earnings are growing fast because the economy is growing fast and the two effects could sort of cancel out. We see that, for example, when you compare emerging markets with advanced economies. The EMs have higher interest rates but they might still trade at much higher price-to-earnings multiples, because the earnings growth is a lot higher. The earnings growth compensates for the yield drag.

But the fear some people have is whether there will be stagflation and so on. That is the scary thing for the equity market, that the earnings don’t grow and the inflation takes away.

So that itself leads us to think that the Fed will resist escalating interest rates to an extent that they affect growth. Since they would want to ensure that the wealth effect is not disrupted. After COVID-19, there is so much more participation in equity.

Yes, that's true. If I were an equity investor in the advanced economies, I would worry that the whole phenomenon of the central bank propping up equity markets was in a period of low inflation. It is one thing for the central banks to prop up capital markets when inflation is benign, when you had the ‘Greenspan put’ (policies by former Fed Chair Alan Greenspan to stop the markets from sliding) and so on, but it is a different kettle of fish when the inflation is looking worrisome. When push comes to shove, the Fed might say that our primary mandate is to contain inflation and not to prop up equity markets. I get a sense that the Greenspan put is past its expiry date.

Finally after 20 years…

Yes. It's a different world in which they are in.

Also, a lot of central bankers have grown up believing that advanced economy central banks failed to respond to the big energy shock of the seventies and that is what caused inflation to get out of hand. That’s what they (the central bankers) would have learned back in their Ph.D programmes and so on, that failure to counteract the big energy price shock was a mistake. Then, when they see an unhealthy (energy) price shock of this kind (with crude going from $40 a barrel to $100-plus a barrel), it looks almost as bad as ’73 and ’79, right? Everything they learnt back in graduate school is that don’t make the mistake of ignoring an energy price shock.

So I doubt that they would care that much about equity markets.

The other thing is that, in the financial sector, most of the advanced economies are in pretty good shape. The banks have lots of capital and credit losses are limited. When hiking interest rates, the central banks would worry more about creating a banking crisis. But now the banking sector can absorb it (with the high capital and low credit losses) and the central banks may think ‘the capital markets are not our baby’ (so rate hikes affecting the capital markets won’t be the central banks’ worry).

If I were to play devil's advocate, central banks around the world –the US, UK, Eurozone–are sitting on the highest levels of debt. In today’s world, who can say that central banks act independently at all? They are, more than anything else, going to be acting in the interest of the government or at least be made to act in the interest of the government. Therefore, the banks would have the greatest vested interest in keeping rates low so that governments don't come under pressure and the governments continue to have some fiscal room.

Yes. Five years ago, the consensus was that the removal of monetary accommodation will start with winding down the central bank’s balance sheet. It is only when central banks’ balance sheets have been lightened that they would start hiking rates in earnest. But today, though nobody's quite explicit about it, increasingly the sense that one gets is that both the Fed and the ECB are comfortable holding on to a multi-trillion-dollar balance sheet while they continue to hike. Saying that, what is needed to stabilise the sovereign bond market is not shrinking the balance sheet too fast. We can maybe stop adding to it, but we can’t shrink it aggressively. But we can hike (rates).

They have bought so much debt that it is enough to stabilise the bond market. They think we can raise rates, since much of the interest rate duration risk is sitting on the central banks’ balance sheet itself, and unwind the balance sheet only by natural redemption and so on, and not anything else.

I think central banks have given up the idea that they could go back to the good old days of a $100-billion balance sheet. They are all now reconciled to $2-trillion, $3-trillion balance sheets. So that takes care of the bond market.

The bigger problem in Europe is if they (the central banks) were to really dump their bond holdings, then definitely countries like Italy could be at risk.

(This is part of a two-part series. Read part one here.)