Nobel Laureate Paul Romer writes that “for more than three decades, macroeconomics has gone backwards.” He sees the economics discipline as no longer being concerned with whether or not its models have any practical relevance and says we have entered an era of “post-real” macroeconomics. Simply put, reality no longer matters to them.
According to most economists, the year 2022 was supposed to be the year of a revival of economic growth. Yet, 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.
First, more than a decade of easy money and low inflation convinced the new generation of central bankers that there were no costs to aggressively accommodative policy. The flood of liquidity and ultra-accommodative monetary policies has simultaneously inflated multiple bubbles. Stocks, bonds, real estate, and speculative investments have all experienced historic inflations and the markets have struggled this year as central banks raise rates and unwind economic support to ease decades-high inflation.
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The problem with unconventional
monetary policy is that, because bad shocks come along with regularity, it's never a good time to normalise.
The global monetary system is currently facing historic challenges. Investors continue to suffer from whiplash as extreme levels of volatility in equity and bond markets reflect stretched levels of pessimism and uncertainty.
Why are we at this place now?
In periods of complacency, the world’s central banks play at mimicking Fed without having the world’s reserve currency or the legal security and financial balance of the
US. When Fed realises its folly and starts setting its house in order, the music stops but other central banks prefer to initially talk down its impact and thereafter try to catch up. Last week was one occasion when so many central banks faced this reality check and the markets could sense a growing sense of urgency, bordering panic, among global central banks.
Aside from 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 post-pandemic demand, especially for goods.
Russia’s war with Ukraine has further exacerbated inflation dynamics, driven above all by a sharp increase in commodity prices, notably energy. More recently,
China’s zero-covid policy and the related lockdowns of important industrial centres have put additional strain on supply chains, which threatens to keep shipping costs and producer prices higher for longer.
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
Central banks are trying to pretend that they are part of the solution although it is ironic that they had indeed created this problem in the first place. Regardless of what central bankers do going forward, the reality is that the world is on the brink of an economic crisis, with confidence in monetary governance at the lowest ebb.
Central banks all over the world have been on a hiking spree of late after having remained as mute spectators for a long and hence the popular narrative: Central banks are behind the curve.
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 a 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 the remedial measures at a hastened pace - largely in the dark. The rate hikes are supersized as they want to catch up with reality. It's like letting the asking rate go sky high before the batting team goes berserk.
The fact is that no one knows just how high the central bank’s short-term rate must go to restrain inflation. The liquidity taps could also run dry soon: Bloomberg Economics estimates that policymakers in the G7 countries will shrink their balance sheets by about USD 410 billion in the remainder of 2022. It’s a stark turnaround from last year when they added USD 2.8 trillion — taking the total expansion to more than USD 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.
US monetary policy
The US now leads the charge for potentially the largest & fastest tightening of global monetary policy in decades. Fed has its work cut out for it in terms of bringing down inflation by pumping the breaks on the economy, without causing it to slip into recession.
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. Powell expressed this neutral rate as somewhere between 2 percent and 3 percent, suggesting that the next few hikes will be 50 basis points, likely followed by the more conventional 25 basis-point hikes through the end of 2022.
50 basis points 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.
Such a dramatic step-up in borrowing costs when the Federal issuances are at a historic high 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.
However, 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.
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 a continued upswing in prices.
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, 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, RBI followed the global monetary policy cycle since the pandemic and tried to emulate Fed by passing off the initial spurt in inflation as transitory and continuing with historic liquidity injections. 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.
In an off-cycle move,
RBI stunned the markets last week by hiking the repo rate by 40 bps to 4.40 percent and increasing the CRR by 50 bps to 4.50 percent. The CRR hike is expected to reduce banking sector liquidity by Rs 870 billion and also reduce the money multiplier. The rationale for the MPC action could be found in the elevated risk for domestic inflation, on the back of higher food prices.
The significance of the timing of the surprise tightening both on the rate front and liquidity front on the day is not lost on the markets. Fed was to announce its decision later in the day and it underlines the urgency of RBI to stay in line with the global monetary policy cycle despite the pressing need to stay accommodative to steer the massive Government borrowing programme.
If their post-lunch 4 May 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 the cycle.
MPC calendar for the rest of the year can very be changed to fit with Fed meetings.
Besides RBI, monetary policy decisions of other central banks during the last week are also worth studying to bolster the case of the trend of higher interest rates
At its May meeting, the Reserve Bank of Australia (RBA) raised the cash rate by 25 basis points to 35 basis points. RBA decided that now was the time to take action after inflation picked up more quickly than expected. In addition, they believe that some withdrawal of the extraordinary monetary support provided through the pandemic is appropriate.
Last week, Chile’s central bank hiked the country’s benchmark interest rate to 8.25 percent, above expectations, from 7.0 percent previously.
Brazilian Central Bank (BCB) also announced a 100 bps rate hike at its May monetary policy meeting, bringing the Selic rate to 12.75 percent. The BCB has embarked on one of the most aggressive monetary tightening schedules in the world and has now raised rates by a cumulative 1,075 bps.
Summing up, a paradigm shift is happening in the monetary policies and it would be prudent to stay prepared for higher rates. Investors should prefer 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 utilize periodic rebalancing to take advantage of volatility by "adding low and trimming high."
Beware 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 "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. Hence it may not be prudent to use conventional wisdom in making financial decisions.
—The author, V Thiagarajan is Advisor at Finrex Treasury Advisors. The views expressed are personal.
(Edited by : Priyanka Deshpande)
First Published: Jun 6, 2022 12:45 PM IST
