Federal Reserve in its meeting on 17th September stunned the Financial Markets by not increasing its Target rates by 25 basis points as was widely expected. Initial reaction was surprisingly a selloff in stock markets across the world. In normal course absence of rate hike should have been positive from risk appetite point of view.
Why is it such a big deal?
The clue to the answer lies in the Federal Open Market Committee (FOMC) statement which gave the reason for lack of action as: “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term”.
Let us rewind a bit to the beginning of Quantitative Easing to make the point
Efforts of Federal Reserve to prevent collapse of financial markets in the aftermath of sub primes crisis are well known. It began with cutting benchmark rates to Zero, followed by broadening the type of assets it funds against and purchase of treasury bonds and operation twist etc. Fed stopped incremental purchase of securities in late 2014 after announcing “Taper” in 2013.
All along the feds view has been that the above measures were extraordinary in nature and would be unwound once the economy recovered.
The idea behind the whole strategy was to discourage savings by keeping rates low and encourage consumption and investment by flooding the market with liquidity. This strategy was perfected by the fed over last two decades, cutting rates every time economy looked like stalling and hiking rates to cool runway boom to engineer soft landing and therefore quicker recovery. It worked as expected during the last cycle which ended with dot com bubble and 9/11. Fed action helped revive economy fairly quickly. But Fed faltered in hiking rates too slowly in 2003-2006, which caused too much leverage and risk build up resulting in spectacular collapse in 2008.
As it is well known, Fed responded with all the ammunition at its disposal and managed to avert a total collapse. But to its surprise despite keeping the extraordinary measures going for almost seven years, economic growth has still been lukewarm, inflation non-existent and consumer spending (which accounts for 70% of US economy) barely growing.
There were many non-mainstream economists and analysts who had predicted that above measures would only postpone and aggravate the inevitable deleveraging. But the Fed in its wisdom went all out along this path. The consequence has been huge distortions in the way market economy functions. Experts like Bill Gross have for years highlighted perils of zero bound rates, but Fed persisted. The key reason for the unexpected outcome has been demographics. 63% of working age population in US is above the age of 40 (Wikipedia). What worked in the past to encourage spending by this population in younger days did not work when they are closer to their retirement. If anything low interest rate only encouraged more savings in an effort to build a retirement nest.
Despite this back drop, the mainstream media/experts and investors continued to have faith in feds ability. The September FOMC meeting was the first occasion when Fed looked vulnerable. Despite firing all its ammunition for six years, Fed did not have faith on the economy to withstand even a measly 25 basis points (1 basis point = 1%/100) rate increase, that too after preparing the market for the event for almost nine months! The excuse of global economic problems only creates more doubts as the problems of China along with commodity/oil producing countries are not going to vanish in foreseeable future. Does it mean Fed remains at zero till these resolve?
On earlier occasions, Fed had began rate hike about 3 to 3.5 years into recovery, but on this occasion it delayed normalising as it felt the recovery has been too fragile.
Like Mr. SS Tarapore pointed out in his column in Businessline, If Fed does not increase rates during a boom, it will have to during the downturn that follows, only to aggravate the bust.
On the global scene, while Europe had also been in borderline recession for last few years, many of the emerging economies led by China are suddenly slowing sharply or slipping into recession territory.
What impact does this have on India?
The main discourse in India on the ongoing turmoil has been on how little dependence India has on China and how fall in commodity prices are good for a net importer like India. There have even been discussions even on how India can replace China (china’s pain=India’s gain)!
The decision makers must realise that there are no winners in a full blown currency war. Every time an exporting country devalues currency it does not just make its export cheaper but also makes its imports costlier. Net result is a shrinking of total volume of trade (already visible in our exports). Commodity collapse also means lesser exports to the producing countries from India. It also means lesser remittances from expatriates in oil producing countries. It also means defaults by foreign currency borrowers in the effected countries, which increases cost of borrowing for Indian borrowers also. Slowing global economy would also impact services export from India.
When Dr. Rajan spoke about Make for India (he was criticised for this) along with Make in India, probably this is what he foresaw! Instead of chasing double digit growth in a slowing world, this is perhaps the best way to face severe global headwinds. Hunker down for the long haul, focus on investments in domestic infra and strengthen economy further.
Written By: KP Jeewan