Global economy: collective hara kiri

Early on Saturday morning, I noticed in my mailbox a series of breathless headlines from The Wall Street Journal about the Dow-Jones Industrial Average index breaking into record new all-time highs intraday and then again at close on the last day of trading in October. Yes, now the S&P 500 stock index too is at an all-time high, having crested the millennial landmark of 2,000 index points. The stock market and stock investors have called the bluff of the Federal Reserve Board (FRB) only because the latter did not choose to call their bluff, when they had the chance.

FRB had their usual once-in-six-weeks monetary policy meeting on 28-29 October. The Federal Reserve Open Market Committee (FOMC) of FRB decided to end its purchase of US Treasury Notes and Bonds and mortgage-backed securities. Thus, their third instalment of quantitative easing (QE3) was over by end-October. FOMC had also removed the reference to the need for a highly accommodative monetary policy after the end of QE3. Many praised the surprising resolve of FOMC to stick to the end of QE3 and to nudge market participants to look ahead to the beginning of a more normal monetary policy where interest rates are positive. The praise would have been reasonably well deserved had members of FRB not come out in full force when the stock market appeared to be heading in the direction of somewhat less insane valuations in the first half of October.

The S&P 500 index had barely dropped some 8% to 9% off its previous highs out came James Bullard, the President of the Federal Reserve Bank of St. Louis, exhorting his fellow travellers at FRB to consider delaying ending QE3 in October. It is possible and even likely that he was not speaking for himself but on behalf of higher authorities at the US Federal Reserve.

In any case, the Federal Reserve might have sounded rather prudent and sober for a change only because it must have been reasonably sure that the Bank of Japan would augment its own QE programme (which it did) and that “whatever it takes” Draghi would follow suit in Europe soon, in the first week of November despite German reservations.

Moreover, the US economy is not resilient enough to rule out the Federal Reserve from more policy adventurism in future. In the last two years (2012Q3 to 2014Q3), the compounded annual growth rate of the US real gross domestic product (GDP) was only 2.3%. Second, as this column has repeated often, the quality of job creation in the US is rather poor. More than 50% of the jobs created since the recession officially ended in 2009 are low wage, long hours jobs. Third, despite the shale revolution, the US real trade deficit (ex-petroleum) as a percentage of US real GDP is approaching the pre-crisis highs (see chart).

Fourth, the shale oil and gas boom is supposed to have brought down the cost of production in energy intensive sectors such as metals, cement, steel and paper. If so, the US should be importing less of these and even exporting them. Where is the evidence? Therefore, the commitment of the Federal Reserve to normalize monetary policy should not be taken too seriously. It will last until the next round of stock market weakness. In the meantime, other central banks are ensuring that financial markets won’t miss the QE programmes of the Federal Reserve

On Friday, the Bank of Japan (BoJ) decided to increase the quantum of Japanese government bonds it is purchasing and exchange traded funds linked to Nikkei-Index 400. The decision is inexplicable. The recent drop in the US dollar price of crude oil is a consumption boost for Japan households. But, it will be diluted by a weaker yen that followed the BoJ decision. Further, Japanese businesses are comfortable with a USDJPY exchange rate that lies in the range of 95 to 105. Further yen weakness is bad for them and for households. Despite a year and half of the latest QE experiment in Japan, confidence among small businesses has fallen. Therefore, the decision to raise the monetary base through asset prices reflects lazy (and dangerous) thinking in Japan.

With politicians polarized and paralysed, central bankers have taken it upon themselves to engage in policy pyrotechnics that would eventually drive markets, investors and economies over the edge into their own Wile e Coyote moment. Yes, investors must shoulder their share of the blame for the current mania.

Even if it makes sense for investors to follow policymakers’ generous provision of liquidity by bidding up asset prices in the short-term, they are supposed to discount the entire stream of future cash flows with a risk-adjusted discount rate. That is how, in theory, rational homo sapiens who populate financial markets impose discipline on policymakers. Instead, there is myopia and instant gratification all around. A sign of times we live in.

V. Anantha Nageswaran is co-founder of Aavishkaar Venture Fund and Takshashila Institution.

Comments are welcome at baretalk@livemint.com. To read V. Anantha Nageswaran’s previous columns, go to www.livemint.com/baretalk

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