The US Federal Reserve said on Wednesday that it would continue to keep interest rates near the lower bound till the unemployment rate in the world’s largest economy remains above 6.5%. The explicit linking of monetary policy to employment marks a new phase in global central banking, though some experts such as Charles Evans of the Federal Reserve Bank of Chicago have been recommending this course of action for nearly six months now.
Full employment is one of the two major goals of the US Federal Reserve, though it has in recent decades preferred to focus entirely on the second goal of low inflation, because the consensus in contemporary monetary economics has been that low inflation will be good for growth in the long run. What does the new policy mean in practical terms? The latest data pegs the US unemployment rate at 7.7%. Though the US employment situation has been improving over the past 30 months, the next 1.2 percentage points drop can take a few more years, especially once people who have stopped looking for jobs re-enter the labour market. So, it would seem that low global interest rates are here to stay for at least another couple of years.
That could prove to be good news for financial markets in India and the other emerging markets. Liquidity is oxygen in the financial markets, and it is no surprise that they saw a recovery from the middle of 2012, when the first talk about more quantitative easing in the West began to do the rounds. The MSCI Emerging Markets Index is up 13.63% in dollar terms since 26 July, while the BSE Sensex is up 19.43% in terms of dollars. Foreign investors have poured in a cumulative $11.24 billion into Indian equities from 26 July to 12 December.
The surge of inflows has provided breathing space for the Indian government, but it is up to New Delhi to use the opportunity strategically rather than getting trapped in vacuous euphoria. The Indian economy continues to struggle, despite the strong growth in factory output in October. Consumer inflation continues to be close to double digits. The fiscal situation is grim. Investments in new capacity have stalled. There are signs that consumer demand has begun to weaken. And the current account deficit is still uncomfortably high.
Easy liquidity offers two immediate advantages. First, it means that it will be relatively easier to finance the external deficit. Second, there will be stronger demand for equity sold by the government in privatization. Of course, there are risks as well, especially the impact of easy liquidity on global oil prices, a stronger rupee and perhaps a domestic asset bubble. So policymakers should use the next few months of easier liquidity as an opportunity to address the more serious structural problems in the Indian economy, because there will be fewer immediate fires (such as a run on the rupee) to be doused.