Opinion
The chorus of central bankers: Higher rates for longer
Summary
Tighter money policies in rich countries are facing off with markets and the outcome will affect India
The picturesque town of Sintra, Portugal, played host last week to an unusually candid conversation between four of the world’s top central bankers: those of the US, Eurozone, UK and Japan. US Federal Reserve Chairman Jerome Powell, Bank of England (BoE) Governor Andrew Bailey, European Central Bank (ECB) President Christine Lagarde and Bank of Japan (BoJ) Governor Kazuo Ueda were at the annual ECB forum on central banking. All excluding Ueda were in sync, repeating the phrases like “data dependent", “meeting by meeting", “robust labour markets" and “resilient growth." They were united in the assertion that they must continue to act to “return inflation to target." Understandably, the BoJ was joining the party from the other end of the inflation-growth spectrum and was on a “watch and see" mode.
If one were to read between the lines, Powell, Lagarde and Bailey seemed to be saying that despite a decline in headline inflation (possibly caused by a greater than expected decline in energy prices), they were more than a bit surprised about how resilient the labour market was in their respective regions. Given this reality, they saw no way to reduce inflation to its target without rates being “higher for longer". The Fed’s dot-plot, an indication of how Fed members think, shows short rates rising to 5.6% from the current 5.0% level (implying two more rate hikes), before holding steady and then declining.
Powell broke down the components of inflation into three ‘sectors’ in the US: the goods sector, housing services sector (which together make up about 50%) and the broad services sector, which makes up the rest. Powell was sanguine about inflation arising from the goods and housing services sector, since they are already showing signs of price stability or disinflation. In his reading, the US services sector, with wages a significant component of profit/loss accounts, has only now begun to show signs of moderation. Powell said several times that for core US inflation to approach its 2% target, policy will need to be restrictive both in magnitude and in terms of time so that “stickier" parts of inflation can soften. In a shocking admission from a central banker, he said that this was unlikely to happen until 2025.
Covid has had a tremendous impact on the macro-economics of developed markets (DM). Lasting effects have come from supply-chain distortions, behaviour changes related to the labour market and the outsized liquidity and fiscal response to the pandemic. These impacts have contributed to inflation on both the supply and demand sides, leaving central bankers the challenging task of having to tackle an unprecedented phenomenon of rising prices.
Within DM, there are substantial differences in the various structural components of different economies. The speed of monetary policy transmission is different in a well-integrated economy like the US compared to a still- integrating and enlarging-on-the-margin economy like the EU (Croatia became the 20th Eurozone country only on 1 January this year). Policy-transmission speed is also affected to a great extent by the proportion of fixed versus variable rate mortgages and their duration. For instance, nearly 85% of UK mortgages are fixed-rate loan deals with a relatively short duration of about 5 years, compared to 96% in the US with a much longer average duration. This dramatically slows down the transmission process.
Markets everywhere seem to disagree with central bankers. For the first six months of the year, the S&P 500 has had a total return of nearly 17%, the Nasdaq 100 has surged nearly 40%, Euro Stoxx 50 Index is up nearly 16% and the S&P high-yield bond index has returned over 5%. Indian stock markets hit all-time highs last week. Markets are quarrelling both with the ‘higher’ and ‘longer’ aspect of the DM central banker’s current playbook. These market rallies have the consequential effect of easing financial conditions, contrary to the effect that central bankers want to create.
In the end, of course, only one side wins. If financial markets are to win, it will be because growth resilience is possible even as inflation comes down. If the Fed’s view wins, then markets will have to grind down to reflect the ‘higher for longer’ reality Powell spoke of. Present valuations in most markets, particularly for growth stocks, are unsustainable if discount rates on that growth are required to be higher for longer.
For emerging markets, including India, the domestic situation is a bit different. Pandemic-time flows from liquidity and fiscal taps were much more measured than those in DMs, and labour-market behavioural impacts far less pronounced. As global supply chains normalize, goods inflation remains more or less in check and domestic inflationary expectations from the services sector are muted.
One mechanism by which DM monetary policy can impact India relates to inward flows of foreign direct investment, portfolio investment and diaspora remittances, the volumes of which are influenced by competition from upward DM money-market rates. Even if Indian growth prospects are viewed favourably, the extraordinary venture capital and private equity inflows of the pandemic years are unlikely to return for quite some time if short-dollar rates remain higher for longer in the Fed’s bid to combat inflation in America.
P.S: “If you do not change direction, you may end up where you are heading," said Lao Tzu
The author is chairman, InKlude Labs. Read Narayan’s Mint columns at www.livemint.com/avisiblehand
