(by Sukhveer Singh, an IAS officer, 27th April, 2022)
Fed’s response to inflationary concerns:
On April 21, 2022, Fed chair Powell said, “a half-point interest rate increase ‘will be on the table’ when the Federal Reserve meets on May 3-4 to approve the next in what is expected to be a series of rate increases this year.” He also mentioned it would be appropriate to move a little quicker. The inflation in the US is running more than four folds the Fed’s 2% target. The Fed chair also expressed disappointment about past forecasts of the inflations where it was expected that it would peak around this time and come down over the next few months.
US economy gained 431,000 jobs in March 2022, and the unemployment rate fell to 3.6 %, close to a target of 3.5%. This data point supports a more aggressive monetary policy to tame skyrocketing inflation. There is evidence that people leave low-paid jobs to accept higher wages offers. The decrease in unemployment was higher than expected and broad-based across all the sectors. The Fed chair mentioned labour market is very tight -even tighter than the pre-pandemic level- and economic growth is robust.
He believes that inflation is more persistent owing to supply-side gaps combined with demand increase, especially in white goods, cars etc. Continued support from the Fed in terms of easy money and trillions of dollars of budgetary support has supported the economy to bounce back. In anticipation of future growth prospects and the manifestation of inflationary pressure have rapidly risen longer-term US interest rates, with the rate on 10-year treasury securities going from under 1 % last year to 2.9 % in April 2022.
The American response to the covid-19 crisis was very swift and specific. It enacted several policies to impart fiscal stimulus to the economy and those affected most by the pandemic. The monetary easing by the Fed accompanied this. These measures led to a fast recovery in the US economy. The US’s GDP, which fell by 3.5 % year over year in 2020, recovered to the pre-pandemic level next year. The unemployment rate rose as high as 14.7 % in April 2020 – the highest since the great depression – and up from 3.8 % in March 2022. However, inflation reached its 40-year high level of 7.95% annual in April 2022.
There are two types of inflation: monetary inflation and non-monetary inflation. Monetary inflation stems from when cash trapped governments create too much of it. And non-monetary is when there are events like bad weather, war, pandemic, any regulatory action, or artificially rising production costs. Today, most global economy sectors are struggling with non-monetary inflation due to supply disruption and subsequently added by fuel and commodity shocks due to the Russia-Ukraine conflict. The economists believe the best way to deal with such a price rise is to let the economy heal and grow.
When asked Christine Lagarde why the European Central Bank (ECB) is not so hawkish even if inflation is skyrocketing in Europe, she replied that we are at different paces of recovery and inflation at various components, so analysis has to do so be different. She stressed that the driving compass for any decision is inflation data at 7.4 % in March 2022, double the target at the end of the year; 50% of it is due to energy prices. Also, consumer inflation, excluding fuel and food inflation, that is, core inflation – mainly due to supply socks- is less than 3%, which is well within a manageable range.
The Fed’s stand to hike the policy rate raises two questions; first, is the labour market tight enough and will it sustain itself for long? The US market sees a strong rebound creating 1.7 million jobs in the first quarter of 2022. The unemployment rate has fallen near historic lows to 3.8%. Evidence suggests that this may be due low participation rate, and the retirees are not coming forward to join the labour force. There may be a case where the natural level of job creation may be higher temporarily to ramp up production to meet the pent-up demand.
Second, has the demand picked up and will it sustain for a more extended period? Data suggest the US had a demand shock towards the demand for goods growing in the first half of 2021 at an annualised basis of 19.5% against an average rate of near 3%. This shows that covid reduced the aggregate demand in the economy significantly. Excessive savings of around $2.4 trillion from delayed spending during the pandemic and unprecedented support from the US government create a sufficient cushion for Americans to spend more in the second half of 2021 and onwards. This increase in the demand for goods could be the reason for the higher core inflation in the US and other advanced countries. However, this demand could subside after some time.
How policy spillover affects emerging and developing economies?
Emerging economies are those which acquire some of the characteristics of the developed economy. They are more integrated with the global market, hold liquidity in the local debt and equity market, have increased trade, have mature financial and regulatory institutions, and exhibit faster economic growth with better livelihood prospects. The economies with higher debt to GDP ratio, weak financial institutions, lower forex reserves, and a higher proportion of short-duration dollar-denominated debt could be categorised as vulnerable emerging economies in the current context of apprehension of rising interest rates in the wake of a worry of capital outflow and currency depreciation.
The financial conditions in the emerging economies have rebounded strongly since April 2020. There has been a significant flow of capital in equity and local currency debt. Lower interest rates at home and ample capital flow have boosted economic growth with range-bound inflation in the last two years. Rising bond yields and higher than expected inflation in advanced economies have raised concerns about the capital outflow from emerging and developing economies.
Vulnerable Emerging economies could be roiled when the Fed start accelerating rate hike from the next meeting. IMF research pointed “Most of the emerging economies are facing a slower economic recovery than advanced economies because of long waits for vaccines and limited space for their fiscal stimulus.” The fear is of a repeat of the taper tantrum episode of 2013 when the rate hike in the US caused an outflow of capital from emerging markets.
IMF reckons that good economic news in advanced economies creates export opportunities for strong emerging markets. It presumes a pickup in economic activities due to goods exports tend to lift their domestic interest rates naturally. As a result, it propounds overall impact to be benign on average emerging markets.
However, a more hawkish policy where an increase in policy interest rate in every Federal Open Market Committee (FOMC) with a 50 bps, 3-4 times in 2022, may lift long term interest rates to create a higher spread on US dollar-denominated debts. This phenomenon of higher yield spread may cause portfolio capital to swiftly flow out of emerging markets and their currency to depreciate against the US dollar. The economies holding longer-maturity debt have a lesser mismatch on the current account balance sheet, and which are resilient to such socks will sustain the possibility of further market differentiation in the future.
In emerging economies, we mainly have supply-side inflation fueled by food and energy prices. These kinds of inflations, particularly in emerging democratic countries, are susceptible to deal with. There are two options: whether to pass it on to the public through raised prices and experience much higher inflation. The second option is to absorb these shocks through fiscal spending in the form of subsidies and reduced taxes on petroleum products. The second option reduces the fiscal space for capital expenditure, which has already been affected negatively due to pandemic related spending. The more significant outflow of capital and tight budgetary space available with the emerging market could jeopardise economic growth and productivity.
Fed rate hike: How does it raise Concerns?
The whole story raises the following concerns: First, the Fed has long maintained a stand that they expected the inflation surge to be ‘transitory,’ as it is primarily driven by supply disruption and demand issues linked to the pandemic. It is pretty natural that this expectation would be a little elongated in the wake of Russia-Ukraine conflict concerns and the consequences of sanctions imposed thereafter. However, the Fed’s changed stance of ‘persistent’ inflation to adopt a hawkish monetary policy raises concerns of due diligence and estimation bias.
Second, many economists and estimates suggest that most part of the inflation is non-monetary, and the Fed or any other Central Bank cannot do anything about it. However, the amount of the inflation linked to the fuel could be eased out a bit if world leaders think of releasing oil from Venezuela, Iraq, and Iran rather than tightening the global trade. Fruitful efforts should be made to deescalate the Russia-Ukraine conflict to remove uncertainties for the future.
Third, there is suspicion that policy rates may not significantly reduce the inflation level, and even if you set interest rates higher, that will squeeze the capital market. What is more, the mortgage payments will go up, demand will fall, and costs will push the economy in the US into a downturn.
When you raise the returns on bonds and derivative returns on cash, the money will flow away from risky assets such as equity, particularly from long-duration growth stocks, towards safe assets such as US treasury bonds. Such flow of money could hamper economic growth in emerging and developing economies and plunge their stock market.
Fourth, the increase in interest rates and the lift-off in bond yields may shudder emerging and developing economies. The economies holding short-term dollarised debt might face quick capital outflow, resulting in a situation of debt repayment default. A notable example is Sri Lanka. The country’s increasingly weak external liquidity position has triggered the risk of debt default.
Fifth, the effect of monetary tightening in the US may tend to be benign for average emerging economies. Still, the countries that export less to the US, rely more on external debt, have not recovered to pre-pandemic level yet could face heat out of this process. The import pressure is likely high owing to higher commodity, fuel, and food prices. This imbalance could strain their current account, and countries with not so significant amounts of forex reserves could be turned to ashes.
Sixth, the uneven distribution of covid-19 vaccines has led to the fear of future lockdowns curtailed investments and consumption; this phenomenon has led to a delay in the recovery in emerging and developing economies. These countries will be forced to increase policy rates in fear of increasing the spread of US dollar-denominated debts, leading to capital outflow and currency depreciation due to the fed rate hike. The cost of money for businesses and consumers will increase, which will impede economic growth.
Seventh, the macroeconomic parameters for the emerging economies will weaken sharply. They would have higher inflation, subdued opportunities for growth, costly money, a weaker currency, a weaker balance sheet to meet import demand, and expensive external financing. Low fiscal space to fire economic growth will add salt to the wound—the inequalities among nations and societies within a country will increase.
How is India Poised?
Foreign Institutional Investors (FIIs), during the ‘taper tantrum’ of 2013, pulled out money from India to the tune of Rs 79,375 crore from the capital market resulting in a depreciation of rupees of over 15% in three months. A rapid devaluation of any currency gives rise to withdrawing more money as FIIs might fear a further fall in the currency and financial conditions.
In Dec 2021, Fed chair Powell announced tapering its asset purchase and ended it by March 2022. The foreign equity outflow from India during the first quarter of 2022 has been $15 billion, 0.5 % of the market cap. However, Indian Rupee depreciated 3% in 2022 so far. Further, this depreciation should not be tagged to the outflow of capital alone; there are many other factors, such as the Russia-Ukraine conflict and the demand-supply gap in petroleum products. This example represents her vital macro-economic parameters, including the better financial health of the banking system, historic high forex reserves of $633 billion, better economic growth outlook, and interdependence of developed countries for imports as an alternative to China.
India’s external debt stands at $619.9 bn at the end of Dec 2021. The external debt to GDP ratio fell marginally to 20 % at the end of Dec 2021, and further, only approximately 52 % of total external debt is dollar denominated. This means that dollar-denominated external debt is half of the forex reserve available. Therefore, many economists feel that India’s foreign exchange reserves would be sufficient against capital flight and currency depreciation if India gets any surprises from Fed.
However, India does not accumulate current account surpluses as forex reserves; India’s Import bill is more than the export bill mainly due to the higher petroleum bill. Thus, most part of India’s forex is accumulated through capital account surplus. This also means that India’s reserves represent borrowed capital, mainly earned by portfolio investments in the bond and equity market. But evidence shows that India has successfully maintained its currency exchange rate and preserved its capital outflow largely.
Indian scheduled commercial banks had non-performing assets as a percentage of gross advances at 11.2% in 2017 – which was a reflection of the dire financial health of the banks in 2013 – and now has declined to 6.9 % in 2021. Improved banking parameters indicate India is in the position to support businesses beyond existing measures, considering the better health of its financial institutions. One could conclude that India is in a sweet spot to significantly absorb shocks created by the Fed rate hike or ‘taper tantrum’.
What can emerging and developing economies do?
Some emerging economies have started to adjust their monetary policy. Brazil, Mexico, Chile and Russia have already hiked overnight interest rates in recent months to address concerns of rising debt and inflation. IMF suggests those with more substantial inflationary pressure and weaker institutions should act quickly. At the same time, those with relatively solid macroeconomic parameters and policy credibility can adopt a gradual path to protect the recovery. In both cases, depreciation of the currency and increasing policy rate would be inevitable. The choice is not easy as they have to trade off a recovery path with safeguarding price and external stability.
Beyond the monetary measures, credible fiscal policy can help build resilience and boost investors’ confidence. These countries can chalk out fiscal reforms to gradually increase taxes, adopt prudential measures in spending, and declare pension and subsidy overhauls.
Concluding Note:
In recent months, the emerging markets with lower current account balances and higher public debt have seen downward movement in their currencies. The capital already has started leaving weaker economies. The economies with subdued growth and weaker financial parameters could create an adverse feedback loop. There seem fewer chances that supply bottlenecks will be removed and war worries will vanish shortly. Adversaries will remain with us for long.
The US, a strong economy with an added advantage of the dollar as a reserve currency of the world economy, may swiftly adapt and absorb its policy change if estimates go wrong. Nevertheless, emerging and developing countries have no choice but to face triple whammy regarding unintended consequences of the pandemic, the war, and the rate hike.
Thus, what is eminent is that all emerging and developing countries should identify and address vulnerabilities to strengthen their financial and regulatory institutions. They should trigger fiscal response, allow central bank independence, and plan preemptive action to beef up appropriate monetary actions.
There is a caveat to the above analysis that spillover shocks to the fragile economies in this interconnected world would also produce spillbacks, affecting advanced economies. One prominent example of spillback would be that fewer exports from emerging economies to the developed economies would create supply shortages and less competitiveness in the domestic market, affecting price stability and economic growth of advanced countries
