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The big dilemma policymakers now face — markets or sustainability?

Any event that might lead to material erosion of the wealth effect will be resisted by politicians and policymakers alike. But trillions of dollars in negative yielding debt, fiscal deficits running at arguably unsustainable levels, signs of unsustainability in asset prices must be bothering the minds and consciousness of the people on the side of righteousness.

June 28, 2021 / 01:18 PM IST

The US Federal Reserve in its latest policy briefing hinted that “it might begin to think” that “when it should begin to think” about the change in its policy stance of near zero interest rates. From whatever the 18 members of the US Central Bank might have uttered at the meeting of FOMC or thereafter, a broad conclusion has been drawn that the wolf might be sighted sometime in the year 2023.

There are a few who “fear” that the wolf may surprise the markets by advancing its appearance in 2022 itself. Notwithstanding, there is a sizable number of experts who continue to believe that wolf of rate hike may not be coming in 2022 or 2023 or even 2024. Some also believe that this wolf does not exist only.

Ms. Market, on its part, has realised that there is nothing to worry for next 12 months, insofar as the Federal Reserve’s monetary policy is concerned. She has therefore decided to follow the “will cross the bridge when we reach there” approach.

The younger brother ECB has decided to side with the markets. The ECB’s President Christine Lagarde recently emphasized “the policy maker has room to cut rates if needed.” It may be pertinent to note here that so far in 2021, no developed country has changed its policy rates. Amongst emerging markets, only Indonesia has cut rates, while five countries (Mexico, Brazil, Russia, Turkey and Czech Republic) have hiked rates.

What does the RBI think?

In its latest policy statement, the Reserve Bank of India did hint that easing inflationary pressures have provided some “policy elbow room”, while reiterating that “at this juncture, policy support from all sides is required to regain the momentum of growth that was evident in H2:2020-21 and to nurture the recovery after it has taken root.”

It would therefore be reasonable to assume that as of today there is no certainty that the next rate move of most central banks would be a hike.

The actual decision to hike or cut policy rates is mostly dependent on real economic data, not perceptions and intuitions. Usually the hikes are after the economic activity has picked materially, output gap has shrunk and inflation has started become threatening.

A rate hike under such circumstances is healthy, for economy as well as markets. There is strong evidence to indicate that markets have usually done very well after healthy rate hikes.

However, at this point in time the worrying aspect is not the probability of rate hike by Fed and other central banks. What is really disconcerting is the incongruence of policy minds. They are not able to define the primary threat to the stability of financial system and economy.

While the popular narrative is moving around inflation and economic recovery, there are distinctive signs indicating that the current inflation may be a supply shock and therefore is transitory.

Insofar as the economic recovery is concerned, it may be Schrödinger's cat. It is possible that the economic recovery is entirely based on the persistent infusion of abundant liquidity and prevalence of near zero or negative rate of interests. A hike in rates or significant withdrawal of liquidity might actually lead to the economy faltering. There is no way to test this hypothesis unless the rates are hiked or liquidity support is withdrawn; and no one would dare do that presently. I say so, because this could upset Ms. Market and she would certainly not like it.

The big question 

This brings me to a very pertinent question “what is more important at this point in time for the policy managers – markets or sustainability?

Inarguably, one of the strongest pillars of the global economic recovery in the past few years has been the wealth effect created by rise in the prices of financial assets. Bonds, equities, and crypto currencies in particular have yielded superior returns, catalysing the consumption and investments. Any event that might lead to material erosion of this wealth effect will be resisted by politicians and policymakers alike.

However, trillions of dollars in negative yielding debt, fiscal deficits running at arguably unsustainable levels, signs of unsustainability in asset prices must be bothering the minds and consciousness of the people on the side of righteousness. The innovative monetary policies adopted post Global Financial Crisis (GFC 2008-09) have miserably failed on sustainability aspect.

The inequalities have risen to appalling levels. The dependency on government support for sustenance has increased even in most developed countries, as not enough sustainable employment opportunities are being created. The treasuries are riding the strongest tiger on the earth. They will have to find some innovative way to end this ride, before the tiger stops on its own to have a meal.

In this context, I note some interesting viewpoints:

Dr Lucy Hunt, a well-known economist has made a strong argument that deflation - not inflation - will win the day going forward, because the current debt, demographic and technological trends are very deflationary. The flood of new $trillions in monetary and fiscal stimulus are just not making it out into the real world. The fabled liquidity is just sitting in bank reserves and will continue to remain that way.

Dr Hunt said in a webinar, “This reveals an important limit of central bank policy. There is a point of diminishing return at which the Fed is truly "pushing on a string". It can shove as much new money into the banking system as it wants, but there's no guarantee that money will make it out into the economy.

And as some of that money invariably finds its way into asset prices, causing them to inflate, corporate executives have a mal-incentive to invest their capital into financial assets vs productivity. The end result is that overall economic productivity is depressed.”

Lisa Beilfuss of Barron’s, raised a direct question at Fed. She wrote, “Investors are calling the Federal Reserve’s bluff. They are right to do so. The Federal Open Market Committee’s latest policy communications raised more questions than answers. Perhaps the biggest one: Can the Fed ever really raise interest rates?”… “The prospect of further fiscal spending would itself make tapering bond purchases a tall order. The Fed has become such a dominant force in the bond market and would presumably need to keep buying the additional debt as the Treasury incurs it. (The Biden administration has proposed a $6 trillion budget for 2022).”

There is strong evidence to indicate that a material part of price may actually be a supply shock and not demand shock, and may need more stimulus to mitigate. The infrastructure push of Biden, Xi Jingping, Narendra Modi et al, are all indicating towards this.

For the record, US inventories are running at 30-year low. The shelves at supper markets are fast getting empty, mostly due to supply chain disruptions.

The demand for used trucks in US is feverish and prices are sky rocketing. As per Freightwaves, “New truck production, beset by shortages of microchips that power critical vehicle functions, and through-the-roof commodity prices, is only beginning to recover but manufacturers are having difficulties hiring enough workers.

It is in the context of this strong market that new truck production is struggling to keep up with strong demand and limiting the used truck market from realising its full potential,” Tam said. “By all indications, demand continues to outpace supply, and for that reason, it should come as no surprise that truck prices continue to increase.”

Vijay Kumar Gaba is Director, Equal India Foundation. Views expressed are personal.
first published: Jun 28, 2021 12:43 pm