BackOther economic concerns may trump inflation worries
Central banks could go the BoE way as jitters surface but RBI should target inflation at least for now
PremiumThe recent British Conservative Party conference held in Birmingham, UK, turned out to be a mega damage limitation exercise. According to political commentator Sebastian Payne, “What was meant to be a coronation for Prime Minister Liz Truss ended up becoming the most chaotic, traumatic, and disunited" conference in living memory.
The proximal reason for the conference disaster was a ‘mini budget’ presented by Chancellor of the Exchequer Kwasi Kwarteng. In the context of a developed world economy battling inflation, the proposals presented by the Thatcherite duo was a combination of £45 billion of unfunded tax cuts, a removal of bonus caps on financial firms and the reversal of a corporate tax increase from 19% to 25%. The original proposal also included the abolition of a 45% income tax on the wealthy, which has since been rescinded. The plan was notably light on any accompanying reductions in public expenditure. If enacted, these proposals would have had the effect of pouring fuel on the inflationary fire by dramatically increasing public debt and undermining the UK’s macroeconomic stability. Markets, in response, said exactly that.
When the UK’s biggest tax cuts in half a century were announced, the pound sterling cratered, bond yields rose and British stocks declined. The pound fell to $1.035, its lowest level in history (it has since recovered slightly) . Ten-year British gilts rose to an annual yield of 4.3% (have since recovered slightly). The sell-off in UK bonds was so rapid that it triggered margin calls in UK pension funds. The British budget watchdog, the Office for Budget Responsibility, was not allowed to present its independent view to the public, and markets took it upon themselves to send a strong signal of discontent about the proposals in the mini-budget. The market consequences and political backlash will add more uncertainty and instability, compounding the after-effects of Britain’s exit from the European Union (EU).
There are many lessons in Britain’s budget debacle. 1) In democracies, when economic principles get bundled with dogma, then the polity sometimes reacts badly. 2) The timing of economic policies, particularly ones that are radically different from the status quo, needs to be carefully considered. 3) Radical policies may be accepted when there is an economic crisis (like in Thatcherite Britain or 1991 India), but careful planning is required when there is only an economic malaise. And 4) harking back to an old economic tool-kit when the global macro-economic regime has changed may result in a loss of trust with citizens and the market. Any reversal would compound this lack of trust.
Liz Truss’s budget plan was spectacularly ill-timed, was defended in doctrinaire terms and at cross-purposes with the action plan at the Bank of England (BoE). The BoE announced a series of measures to combat the instability, including the emergency purchase of long-dated gilts. In an extraordinary statement, it said, “We stand ready to restore market-functioning and reduce any risks from contagion to credit conditions for UK households and businesses."
Around the world, markets are gradually turning their focus from inflation to other measures of economic stability. As the dollar has gained dramatic strength over this year, the probability of material impacts on economic stability and spillovers into credit conditions is increasing, particularly outside the US. We appear to be entering a new economic phase in the post-pandemic world. Phase 1 saw dramatic monetary and fiscal expansion, particularly in developed markets, to combat the pandemic. Phase 2 was the ‘inflation is transitory’ period in late 2021. Phase 3, which we are now in and is led by the US Federal Reserve, is ‘we will do whatever is necessary to combat inflation’. Phase 4 that we may be entering after the British market debacle will be ‘we will do what is necessary and prudent to maintain system stability and bring down inflation’. I suspect that means that the Fed’s dot-plot, a current gauge of the Fed’s forward-looking views on its policy rates, is likely to peak early and unlikely to reach a figure of 4.6%.
If the Fed remains in Phase 3 and other markets, including the UK, emerging markets and India move to Phase 4, then the likelihood increases for significant volatility in currencies, bonds and stock markets.
This uneasy period may also trigger a more sustained Phase 5, where the received wisdom of maintaining 2% inflation for developed markets and 4% inflation for emerging markets begins to drift upwards. An ageing global population and a global savings glut would maintain pressure on rates to stay generally low in the longer term. On the other hand, geopolitical realignments and their impact on supply chains, non-economic partnership choices, fiscal mistakes or accidents and large-scale investment in climate action will all push rates and prices upwards. Whether this must balance precisely at 2% for the developed world and 4% for emerging markets will be the debate that emerges between politicians and technocrats. India, which was among the last of the world’s major economies to adopt an inflation targeting regime in 2016, should elect to benefit from the discipline of this regime for a while longer before it joins the ‘higher inflation is acceptable’ camp.
P.S. “How poor are they that have not patience. What wound did ever heal but by degrees?" said Shakespeare in Othello.
Narayan Ramachandran is chairman, InKlude Labs. Read Narayan’s Mint columns at www.livemint.com/avisiblehand
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