Vijay Kumar Gaba

The Federal Open Market Committee (FOMC) of the US Federal Reserve decided to hike the benchmark bank rate by 75bps to 1.5% - 1.75% on Wednesday. The Committee also reiterated that the Fed will continue to shrink its balance sheet by US$47.5bn till August 2022 and from September the unwinding will be stepped up by US$95bn/month. The FOMC noted that there is no sign of broader slowdown in the economy, while lowering its GDP growth forecast for 2022 to 1.7% from 2.8% earlier. The FOMC statement reiterated the strong commitment to achieve the 2% inflation target. The Fed Officials projected raising it to 3.4% by year-end, implying another 175 basis points of tightening this year. The projection shows a rate cut in 2024.

In the post meeting press meet, Chairman Powell commented that “Either a 50 basis point or a 75 basis-point increase seems most likely at our next meeting. We will, however, make our decisions meeting by meeting.” The Chairman added that ““It does appear that the US economy is in a strong position, and well positioned to deal with higher interest rates.”

The US markets reacted favorably to the FOMC decision. The benchmark S&P500 ended 1.46% higher and 10yr benchmark yields fell 3% to 3.29%. 

Lately, I have been reading a lot of views and opinions about the likely outcome. There are strong arguments for a long corrective phase in the US Economy, just like Japan witnessed post the fiscal and monetary profligation of the 1970s. This Volckerish view anticipates a hard landing for the US economy; tremors across the world and gradual decoupling of global markets from the US markets. The other, equally stronger view is aggressive Fed hikes and tightening taming inflation but not without material demand destruction (recession) followed by a deflationary cycle. This Greenspanish view implies a soft landing for the US economy, premature end to Fed tightening and restoration of “Fed Put” for quick market revival.

Besides, there are multiple views that completely deny the independence of the US Fed from domestic politics and geopolitics. One view, though not convincing enough, portends that the US Fed will be forced to abandon its tightening stance before the mid-term polls begin in the US. The other view is that the inevitable end of current hostilities between Russia and Ukraine would mark the end of the global supply chain woes, resulting in reversal of cost pushed inflation; and the global central bankers’ focus will return to financial stability and growth.

Honestly, with each page of additional reading my confusion has compounded exponentially. In fact, I am confused, like never before, about the basic economic concepts like interest rates, inflation, free markets etc.

What I studied in school was that “inflation” is the rate of rise in prices of goods and services over a defined period. For example, if I could buy a basket of groceries for Rs1000 in June 2021; and I have to pay Rs1100 for the same basket in June 2022; the rate of annual inflation for June 2022 is 10%. If the same rate of inflation persists, the price I would need to pay for the same basket in June 2023 would be Rs1210.

If my income grows at the same rate during this period, I will continue to buy the same basket and there would be no change in my lifestyle (just for example). If my income does not grow by 10%, I will have to cut my consumption or borrow money to maintain my lifestyle. In the first case, the demand for groceries would fall and the seller will be forced to cut prices and the inflation will come down and I will be able to afford the same basket of groceries after some time. In the second case, the inflation for groceries will not come down as the demand sustains; but the demand for money (credit) will rise resulting in higher price for money (interest rates). This means in a simple environment higher interest rates and higher inflation could have positive correlation and move in tandem.

However, the inflation-interest rate correlation will turn negative if (in the above example) I borrowed money in the year 2021 itself and I cannot make additional borrowing to meet higher cost of groceries. In this case, even if my income grows to match the grocery inflation, I will have to cut my consumption to meet the rise in my interest expense.

This implies that other things remaining the same, and it being a free market economy, the correlation of inflation and interest rates would depend on the extent of extant leverage in the economy.

The situation however gets complicated when the largest consumer and borrower (the government) is in a position to control the price of money (interest rates) and/or goods & services. For example, if the government (or central bank) increases money supplies and also cuts the price of money (interest rate) the consumption demand could become artificially high, resulting in higher consumer price inflation. The problem gets further complicated if the government is able to manipulate the purchasing power of the currency (exchange rate) and thus also artificially contain the consumer inflation.

The present situation in the US, as per my understanding, is like this:

The US Fed has increased the money supply (M2) by more than ~3x in the past 13years; while maintaining the price of money (interest rates) close to zero. The exchange rate of USD (DXY Index) has appreciated by about 25% during this period. The inflation was therefore artificially suppressed for over a decade.

The “shutdown” of the global economy in the wake of the pandemic breakout, made the cheaper money and expensive currency irrelevant as the real goods and services were in short supply. The war in Europe further complicated the situation of goods and services supply.

Now, the US central bank is trying to find a lower demand-supply (price) equilibrium by (a) reducing the money supply; (b) increasing the price of money (to contain the consumption demand) while (c) maintaining the currency exchange rate at high level (to ensure cheaper imports).

The debate now is about the trajectory of (i) consumption demand destruction; and (b) improvement in supply of goods and services. A steep fall in demand and steep improvement in supply chains could normalize the situation without much damage to the basic fabric of the economy. However, if the trajectory is flatter, the pain may linger on for years or may be decades.

The other solution could be to control the consumption and prices of goods and services also (Marxist model). This will obviously destroy the basic fabric of the US economy as it stands today.

Insofar as India is concerned, our situation is fairly simple. We have limited leverage and the government intermittently controls the prices of money as well as goods & services, especially during the period of crisis. We just need to pray to Lord Indra for good rains and pray to Lord Ganpati for giving some sanity to Mr. Putin and Mr. Zelenskyy. If these two prayers are answered favorably, we shall be in a position to decouple from US markets and charter our own course (or find a more favorable benchmark to follow). Rest all is ok.