By saying it will keep policy rates “exceptionally low” till mid-2013, the US Federal Reserve is just buying time. It’s hoping that in two years the deleveraging needed to get the economy out of its rut will be done and growth can resume. But looked at another way, the Fed is saying it expects the US economy to be weak for the next two years. That’s very different from what the markets were expecting a short time ago.
Also Read | Manas Chakravarty’s earlier columns
The International Monetary Fund had in June 2011 forecast that growth in the US gross domestic product (GDP) would increase from 2.5% in 2011 to 2.7% in 2012. The World Bank was even more optimistic, forecasting that US GDP growth would increase to 2.9% in 2012 from 2.6% this year. Those numbers now need to be revised downwards and the impact should be felt in the US equity markets.
The Fed also signalled that it would do all it can if conditions deteriorate, a reference to a third round of quantitative easing. That should keep liquidity abundant and the carry trade in fine fettle. Once the dust settles, risk appetite should be back.
The Fed’s measures, of course, do nothing to address the structural problems the Western economies suffer from. The plain facts are that loose monetary policy hasn’t worked and Western governments have tied their own hands on fiscal policy. Under the circumstances, it would be futile to believe the Fed can produce rabbits out of its hat. The supply of rabbits has run out. The continuing rise in gold prices, even after the Fed’s announcement, is an indication the market knows it’s a fudge.
Nevertheless, the fact remains that liquidity will be abundant and, as always, the question is how much of it will be attracted to our shores. Recall that at the time the second round of quantitative easing started, there were big expectations that it would lead to a flood of liquidity into our equity markets. Nothing of the sort happened. Instead, the money flowed into commodities and led to higher inflation in emerging markets, including India, while at the same time pruning margins and hurting corporate earnings.
But with India being one of the bright spots globally so far as growth is concerned, foreign institutional investors are now taking a relook at the Indian market. So far, the argument was that the market was not attractive because of high inflation. With the Reserve Bank of India (RBI) continuing to tighten the screws on the economy, what was the point of investing in India?
The unexpected 50 basis points increase in its policy rate by RBI in late July effectively scotched hopes that inflation was topping out and the central bank was close to the end of its interest rate cycle. One basis point is one- hundredth of a percentage point. But now that the global environment for growth has deteriorated, and especially with the downward shift in crude oil prices, the case is once again being made that RBI might pause at its next meeting in September. In other words, the end-of-the-interest-rate-cycle argument is once again been aired.
What is critical is the outlook for inflation and what RBI will do. On inflation, while it’s true that oil prices are lower, will the loose monetary policy in the West lead to a bubble in commodities once again? The central bank seems to believe so, if its latest monetary policy statement is anything to go by. Here’s what it said: “Should the recovery (in advanced economies) stall, the easy liquidity conditions will continue to prevail leading to continued speculative positions, which may prevent prices from softening.”
But there is a fundamental difference between fund flows when the second round of quantitative easing was announced and the current situation. At that time, fears of a double dip in the US had receded and the hope was that a recovery was finally on its way. This time, the US central bank is saying there won’t be a recovery till mid-2013. Won’t that lower appetite for commodities?
Even if international commodity prices remain low, concerns remain about inflation. Food inflation, for example, is a worry and RBI’s monetary policy statement had pointed to higher minimum support prices and said there were risks to the outlook for food prices. The statement had also said the high fiscal deficit was another risk.
Further, even if crude oil prices remain low, the scope for cutting domestic fuel prices is limited, simply because they hadn’t been revised high enough earlier. Moreover, as the RBI statement said, administered prices for power and coal are also likely to see upward revisions. And finally, both RBI and the Prime Minister’s economic advisory council had said that inflation would remain high till September-October.
What about growth? The latest PMI readings for July show that the overall economy actually expanded at a faster rate than in the previous month, thanks to strong growth in services. True, exports will be affected by a weak global economy, but it’s doubtful whether the fall in growth will be so dramatic as to change the central bank’s stance.
In short, the central bank’s earlier statements suggest that while it may pause in September, the recent market melt-down may not be sufficient to reverse its stance. That will happen only if there’s a shock to the global system, which is quite possible, especially from Europe. But if policymakers in the West are successful in their game of kicking the can of worms down the road, then, as RBI has said, “A change in stance will be motivated by signs of a sustainable downturn in in?ation.”
Manas Chakravarty looks at trends and issues in the financial markets. Comment at firstname.lastname@example.org