Vijay Kumar Gaba

 I have often seen that when we fail to find solutions to our problems with the help of science and economics, we tend to look towards the heavens and seek to find answers in philosophy. It is not uncommon for businesses, administrators, and policymakers to seek divine intervention when science and economics are not helping to resolve a problem. The global policymakers and administrators seem to have reached such a crossroads one more time, where the conventional practices, accumulated knowledge, and past experiences do not appear to be of much help. Their actions appear driven more by hope than conviction.

The war in Ukraine; the economic slowdown in China; and the monetary policy dilemma in the US and India are some examples of problems where the administrators and policymakers seem to be hoping for divine intervention. I see the recent speech of the US Federal Reserve Chairman Jerome Powell at the Jackson Hole symposium and the minutes of the last meeting of the monetary policy committee of the Reserve Bank of India in this light.

After 16 months of aggressive monetary tightening, the Fed is not confident whether they have done enough; or they have overdone with tightening or they are lagging behind. He reiterated that the policy is restrictive enough to anchor inflationary expectations, but still expressed fears that the high inflation might get entrenched in the economy and may require treatment at the expense of higher unemployment. Chairman Powell indeed sounded more like a sailor trapped in a storm, when he said, “We are navigating by the stars under cloudy skies”.

The situation in the US, as I see it from thirty-five thousand feet above sea level, is as follows:

·         The US Federal Reserve has hiked the key policy rates from near zero (0.25%) in March 2022 to 5.5% in August 2023. This is one of the steepest hikes in the past four decades.

·         The US financial system faces a serious challenge as MTM losses on the bond portfolios are accelerating; retail delinquencies have started to build up;

·         The positive real rates in the US are now 2% or higher. Despite these restrictive rates, the economy is not showing much sign of cooling down. The probability of growth acceleration in the US economy in the next couple of years is therefore remote.

·         Inflation continues to persist above 4% against a committed target of 2%. The household savings may therefore continue to shrink at an accelerated pace.

·         The mortgage rates are well above 7%, the highest in two decades. Housing affordability is at its worst in history.

·         The US government is paying close to US$1trn/year (about 20% of revenue) in interest on its borrowing, which is an unsustainable level.

·         The cost of borrowing (and interest burden) for the US government shall continue to rise for a few years at least as the Fed reduces its balance sheet, foreign governments cut on their demand for the US treasuries, and the rating of the US government’s debt face further downgrades. The fiscal pressures thus remain elevated.

·         The money supply (M1) in the US at US$19trn is about 4.5x of the pre-Covid levels. It may take years to normalize at the current speed of quantitative tightening (QT) by the Federal Reserve.

·        
The “Lower for Longer” narrative has metamorphosed quickly into “Higher for Longer”. However, analysts, economists, and strategists who are in their 30s may have never witnessed a major rate or inflation cycle in their professional careers. Their assessment of peak rates and peak inflation may be suffering from some limitations.

….to continue tomorrow

Last week media headlines prominently mentioned that Michael Burry, the famous fund manager who earned his clients billions by positioning short on the US securities during the subprime crisis of 2007-08, has recently bought put options on S&P500 and Nasdaq100 worth totaling US$1.6bn in nominal value.

 One of the elementary principles of economics is that the price of anything is determined by the equilibrium of demand and supply. Though sometimes, in the short term, a state of inequilibrium may exist leading to higher volatility in prices; the equilibrium is usually restored by operation of a variety of factors. This principle usually applies to all things having an economic value, including currencies, gold and money (capital). The traits of human behavior like "greed", "fear", "complacence", "renunciation", and "aspirations" are usually accounted for as the balancing factors for demand and supply and not considered as determinants of price as such.

However, the case of currencies and capital is slightly complex given currency’s dual role as a medium of exchange and a store of value; and use of money as a policy tool to achieve the objectives of price stability, financial inclusion, poverty alleviation, social justice etc.

As a medium of exchange, price of currency is mostly a function of demand and supply of that currency at any given point in time. Higher supply should normally lead to lower exchange value and vice versa. The demand of the currency as medium of exchange is determined by the factors like relative real rate of return (interest), terms of trade (Trade Balance etc.), and inflation, etc. in the parent jurisdiction.

As a store of value, the price of a currency is, however, materially influenced by the faith of the receiver in the authority issuing such currency. For example, to the transacting parties, promise (since the currency is nothing but a promissory note) of the US Federal Reserve may hold much more value than the promise of, say, the Reserve Bank of Australia; regardless of the fact that the Australia runs a current account surplus, has lower interest rate, a similar inflation profile and a much stronger central bank balance sheet (as compared to the US Federal Reserve) and public debt profile. (1.50AUD=1USD)

Similarly, price of money (Interest rates) is usually a function of demand and supply of the money in the financial system. Demand for money is usually impacted by the factors like level of economic activity and outlook in the foreseeable future; whereas supply of money is mostly a function of risk perception; relative returns and policy objectives.

In Indian context, exchange value of INR, 10yr benchmark yield and crude oil prices evoke much interest. Interestingly most economic growth forecasts appear predicated on these, whereas logically it should be the other way round. Politically also, the USD-INR exchange rate is a popular rhetoric of the politicians on all sides of the Indian political spectrum. Recently, the rise in the international acceptability of INR has become a popular plank of the incumbent government; though there is little evidence of this happening as yet. The politicians refuse to acknowledge that INR depreciation is a normal economic phenomenon, and there is nothing at present that can reverse it.

To further emphasize my point, I may reiterate the following narration from one of my earlier posts.

“In the summer of 2007, I had just moved to the financial capital Mumbai from the political capital Delhi. The mood was as buoyant as it could be. Everyday plane loads of foreign investors and NRIs would alight at Mumbai airport with a bagful of Dollars. They would spend two hours in sweltering heat to reach the then CBD Nariman point (Worli Sea link was not there and BKC was still underdeveloped), and virtually stand in queue to get a deal where they can burn those greenbacks.

Mumbai properties were selling like hot cakes. NRIs from the Middle East, Europe and US were buying properties without even bothering to have a look at them. Bank were hiring jokers for USD 100 to 500k salary for doing nothing. I was of course one of these jokers!

That was the time, when sub-prime crisis has just started to grab headlines. Indian economic cycle started turning down in spring of 2007, with inflation raising its head. RBI had already started tightening. Bubble was already blown and waiting for the pin that would burst it.

INR had appreciated more than 10% vs. USD in the first six months of 2007. However, since January 2008 (INR39=1USD) INR has depreciated over 112% till now (INR82.6=1USD). In the meantime, the Fed has printed USD at an unprecedented rate; and there has been no shortage of supplies of EUR, GBP and JPY either.

The point I am making is that in the present times when the balance sheets of most globally relevant central bankers are running out of space to accommodate additional zeros and their governments are still running fiscal deficits are with impunity to service the mountains of their debts and profligate policies, the value of currency is definitely not a function of demand and supply alone. Regardless of economic theory, it is the faith of people in a particular currency that is the primary determinant of its relative exchange value.

2005-2007 was the time when the Indians had developed good faith in their currency, due to high economic growth. Local people were happy retaining their wealth in INR assets, despite liberal remittance regulations and NRIs were eager to convert a part of their USD holding in INR assets. The situation changed in 2010 onwards. There is no sign of reversal yet. Despite the huge popularity of the incumbent prime minister amongst overseas Indians, we have not seen any material change in remittance patterns in the past six years. Despite tighter regulations, local people appear keen to diversify their INR assets. Most of the USD inflows have come from "professional investors" who invest others' money to earn their salaries and bonuses. These flows are bound to chase the flavor of the day, not necessarily the best investment. Whereas the outflows are mostly personal, or by corporates with material promoters' stakes. Even FDI flows have reportedly slowed down in the past one year.

In my view, no amount of FII/FDI money can strengthen INR if Indians do not have faith in their own currency. Yield and inflation have become secondary considerations.

Recently, the Reserve Bank of India released the “Report of Inter Departmental Group on Internationalisation of INR”. The IDG recommended a pathway to be followed for inclusion of INR in IMF’s SDR basket in the “long run”. Tomorrow, I shall discuss the recommendations of IDG tomorrow, in light of my assumptions.

 In its latest flagship Global Economic Prospects (June 2023) report, the World Bank has highlighted numerous weak spots in the global economy, which if not handled promptly and properly could result in a financial crisis culminating in a deep downturn in 2024.

The report emphasizes that the global economy is far from full recovery from the impact of coronavirus induced slowdown. It severely lacks the strength necessary to make progress on “global ambitions to eliminate extreme poverty, counter climate change, and replenish human capital.”

It is further emphasized that “years before COVID-19 arrived, governments had already been turning their backs on free and fair trade. And long before the outbreak of the pandemic, governments across the world had developed an appetite for huge budget deficits. They turned a blind eye to the dangers of rising debt-to-GDP ratios. If a lost decade is to be avoided, these failures must be corrected—now, not later.”

The following are some of the noteworthy excerpts from the 186 pages report released earlier this week.

·         All the major drivers of global growth—including productivity, trade, labor force and investment growth—are expected to weaken over the remainder of this decade. Potential growth—the maximum growth the global economy can sustain over the longer term without igniting inflation—is expected to fall to a three-decade low over the remainder of the 2020s.

·         Emerging markets and developing economies (EMDEs) lack wherewithal to create jobs and deliver essential services to their most vulnerable citizens. These problems must be tackled promptly if the world is to establish the economic footing necessary for even a semblance of success on global development goals.

·         Despite the steepest global interest-rate hiking cycle in four decades, inflation remains high; even by end-2024, it will remain above the target range of most inflation-targeting central banks. Policymakers in most economies will need to be exceptionally agile to cope with the risks that come with such rate hikes. Today, high interest rates aren’t merely crimping growth in EMDEs; they are also dampening investment and intensifying the risk of financial crises. These challenges would intensify in the event of more widespread banking-sector strains in advanced economies.

·         The world economy will remain frail—and at risk of a deeper downturn—this year and in 2024. Our baseline scenario calls for global growth to slow from 3.1 percent in 2022 to 2.1 percent in 2023, before inching up to 2.4 percent in 2024. Even this tepid growth assumes that stress in the banking sector of advanced economies does not spill over to EMDEs.

·         Rapid interest-rate increases of the kind that have been underway in the United States over the past year are correlated with a higher likelihood of Foreword financial crises in EMDEs. And if the current banking stress in advanced economies metastasizes into widespread financial turmoil affecting EMDEs, the worst-case scenario would have arrived: the global economy would experience a deep downturn next year.

·         Interest payments are taking an ever-bigger bite out of these resources—more than one-fifth of revenues in many countries—leaving them with little fiscal space to cope with the next shock or make the investments necessary to revive growth.

Global Outlook

Growth: The global economy remains in a precarious state amid the protracted effects of the overlapping negative shocks of the pandemic, the Russian Federation’s invasion of Ukraine, and the sharp tightening of monetary policy to contain high inflation. The resilience that global economic activity exhibited earlier this year is expected to fade.

Growth in several major economies was stronger than envisaged at the beginning of the year, with faster-than-expected economic reopening in China and resilient consumption in the United States. Nonetheless, for 2023 as a whole, global activity is projected to slow, with a pronounced deceleration in advanced economies and a sizable pickup in China.

After growing 3.1 percent last year, the global economy is set to slow substantially in 2023, to 2.1 percent, amid continued monetary policy tightening to rein in high inflation, before a tepid recovery in 2024, to 2.4 percent. Growth in advanced economies is set to decelerate substantially for 2023 as a whole, to 0.7 percent, and to remain feeble in 2024. In EMDEs, aggregate growth is projected to edge up to 4 percent in 2023, almost entirely due to a rebound in China following the removal of strict pandemic-related mobility restrictions.

Global growth could be weaker than anticipated in the event of more widespread banking sector stress, or if more persistent inflation pressures prompt tighter-than-expected monetary policy. Weak growth prospects and heightened risks in the near term compound a long-term slowdown in potential growth.

Inflation: Inflation remains above target in almost all inflation-targeting economies. With supply chain pressures easing and energy prices declining, excess demand appears to be a key driver of continuing high inflation in advanced economies, though lingering impairments to supply capacity may also still play a role.

India: In India, which accounts for three-quarters of output in the South Asia region, growth in early 2023 remained below what it achieved in the decade before the pandemic as higher prices and rising borrowing costs weighed on private consumption. However, manufacturing rebounded into 2023 after contracting in the second half of 2022, and investment growth remained buoyant as the government ramped up capital expenditure. Private investment was also likely boosted by increasing corporate profits. Unemployment declined to 6.8 percent in the first quarter of 2023, the lowest since the onset of the COVID-19 pandemic, and labor force participation increased.

India’s headline consumer price inflation has returned to within the central bank’s 2-6 percent tolerance band.

Growth in India is expected to slow further to 6.3 percent in FY2023/24 (April-March), a 0.3 percentage point downward revision from January. This slowdown is attributed to private consumption being constrained by high inflation and rising borrowing costs, while government consumption is impacted by fiscal consolidation.

Growth is projected to pick up slightly through FY2025/26 as inflation moves back toward the midpoint of the tolerance range and reforms payoff. India will remain the fastest-growing economy (in terms of both aggregate and per capita GDP) of the largest EMDEs.

(Full report is available here)

 The Federal Open Market Committee (FOMC) of the Federal Reserve of the US announced another 25bps hike, taking its key fed fund rate toa target range of 5.00 to 5.25%. This unanimous decision of the FOMC is the 10^th straight hike in the past twelve months. With this hike, the effective fed fund rate is now highest since the global financial crisis. Besides the hike, the Fed also maintains the plan to shrink the balance sheet each month by $60 billion for Treasuries and $35 billion for mortgage-backed securities.

…claims banking system “strong and resilient”

Noting the concerns in the financial markets, especially those arising from the failure of Signature Bank, Silicon Valley Bank and First Republic Bank, the FOMC emphasized that "The U.S. banking system is sound and resilient. Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain. The Committee remains highly attentive to inflation risks."

…reiterates “growth modest”, “job gains robust” and “inflation elevated”

The FOMC noted that recent data suggest that growth has been modest while “job gains have been robust” and inflation is “elevated.” Reiterating its commitment to the 2% inflation target, the Committee cautioned about the further slowdown in economic growth due to tighter credit. FOMC post policy meeting statement read, “tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain. The Committee remains highly attentive to inflation risks.” This is very similar to what the FOMC had stated in previous policy statement in March 2023, which had come just after the collapse of Silicon Valley Bank and Signature Bank.

…stops short of saying “pause”

The latest FOMC statement omitted the previous wording ““some additional policy firming” and instead said it “will take into account various factors “in determining the extent to which additional policy firming may be appropriate”. Analysts largely interpreted this change as a signal for pause from the next meeting in June 2023; though no one suggested that any policy easing may be imminent.

The US Federal Reserve Open Market Committee (FOMC) decided to hike the key federal fund rate by 25bps to 4.75% - 5% range. This is the eighth straight hike decision by the FOMC since the Fed started its fight against inflation in March 2022; bringing the rates to highest since September 2007.

Speaking to the press post FOMC meeting, the Fed chairman Jerome Powell, dismissed the speculation about any imminent rate cuts, stating “FOMC participants don't see rate cuts this year, it is not our baseline expectations”.

The post meeting statement of FOMC indicated that the policy may remain sufficiently restrictive though future hikes shall be data dependent. The statement read “The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time” and “The Committee will closely monitor incoming information and assess the implications for monetary policy”.

The market participants interpreted the statement to imply that at least one more rate hike of 25bps will be done this year, before the Fed hits a pause button.

Powell emphasized that the Fed is “committed to restoring price stability, and all of the evidence says that the public has confidence that we will do so.” Speaking about the recent banking sector crisis, the chairman assured that “US banking system is sound and resilient” and the Fed is “prepared to use all of its tools to maintain stability.” He however admitted that recent banking turmoil is “likely to result in tighter credit conditions for households and businesses, which would in turn affect economic outcomes.”

The Fed maintained that the current pace of quantitative tightening (QT) shall continue, though recent emergency measures to mitigate the impact of the banking crisis have resulted in expansion of its balance sheet.

The US equities ended the session with a cut of 1.6%; while US dollar index 9DXY) lost 0.7%.

In the past one year, inflation has been one of the primary concerns for most countries across the globe. Rising prices of food and energy in particular have materially impacted the lives of common people on all continents. The central bankers of most major economies have hiked policy rates in the past one year to control inflation. In the current year 2023 so far, 13 major central bankers have taken policy action(s) and all of these actions have been hike in policy rates.

However, in recent weeks inflation has shown some tendency of cooling down. It is difficult to assess how much of this cooling down is due to tighter monetary conditions; and how much could be attributed to other factors like restoration of supply chains that were broken during the pandemic and warmer winters resulting in lower energy demand in the northern hemisphere, etc. Nonetheless, some central bankers have adjusted the pace of tightening to smaller hikes. Most of them, though remain circumspect about the persistence of inflation. While the debate continues over the trajectory of price hikes in the next few quarters; an overwhelming majority of experts believe that prices may remain high for much longer.

The global growth forecasts have witnessed some downgrades in the past six months as tighter monetary conditions and higher prices are seen hurting demand for consumption and investment. As per the latest assessment of the World Bank, in 2023 “the world economy is set to grow at the third weakest pace in nearly three decades, overshadowed only by the recessions caused by the pandemic and the global financial crisis….Major economies are undergoing a period of pronounced weakness, and the resulting spill-overs are exacerbating other headwinds faced by emerging market and developing economies (EMDEs).” 

With this background, three key issues that could influence the future trajectory of global prices and therefore interest rates are geopolitical situation; impact of China ending Covid restrictions and the impact of the emergence of El Nino on global food production.

Geopolitical conflict in Eastern Europe (Russia-Ukraine) has materially influenced the prices of energy and food in the past one year. Any worsening or this conflict or expansion to Western Europe could make things worse. Some events in the recent weeks have indicated that Sino-US relations may not improve anytime soon. NATO countries hardening their stand on Russia; Russia retaliating with a cut in energy output; and some key OPEC members openly expressing disagreements with US oil pricing has materially increased the uncertainty in the energy market.

China has been gradually relaxing the covid restrictions for the past many months. This has eased the logistic logjam across the world. The supply chains that were broken due to congestion at major ports, shortage of containers, short supply of key raw materials, and poor take-off have mostly been repaired. The freight rates that had become prohibitively high have eased to pre Covid (2019) levels. The debatable question however is whether China reopening will be inflationary (higher demand) or deflationary (complete supply chain restoration and consequent destocking; improved mobility of workers etc.).

As per the latest forecast of various weather agencies (see here), the probability of El Nino conditions developing in the coming summer could impact the agriculture production in major countries like India, this year. If these forecasts come true, we may see food prices remaining at elevated levels.

A variety of views prevail on these three issues and their outcome. In my view, China reopening will indubitably be deflationary for the global economy, especially metals and other raw materials).

I am however not sure about the geopolitical conditions. I would therefore continue to expect elevated crude oil prices through 2023. By the way, the RBI in its latest statement has assumed the price of Indian basket of crude oil to be US$90/bbl for FY24, against the current price of US$84.19/bbl (see here).

It is little early to talk about weather conditions in the forthcoming summer and its eventual impact on global food prices. For now, the Rabi crop in India appears to be good; and there is enough food in the Indian granaries. Thus availability of food should not be a problem for sure even if we had a poor monsoon year after three normal/excess monsoons.

In the US, banking panic started at regional level in 1930, with many smaller regional banks faced crisis. However, as Great Britain decided to leave the gold standard for GBP on 21 September 1931, the panic spread throughout the country. Foreigners became concerned that the US may also follow Great Britain and end gold convertibility of USD. There was a rush to convert USD into gold. The collateral was that depositors became concerned about the safety of their money and started withdrawing currency from their accounts. A global rush to convert USD into gold and an internal rush to withdraw currency from banks drained out the banking system reserves and choked the money supply – exacerbating the deflation and propagating the great depression. There was a spate of bank failures in the US during 1931-1933.

The Federal Reserve Bank of New York responded to the situation by hiking rates in October 1931, to encourage investors to deposit money in the US banks or buy US bonds. There was an immediate relief, but that did not last long. The Fed started buying bonds from the market in 1932 and hiked the rates again in February 1933. It did not help much in restoring the confidence of investors in USD. In March 1933, the Federal Reserve Board suspended the gold standard for USD; President Roosevelt announced a national bank holiday and suspended all outbound gold shipments. The provisions that allowed the holders of specific treasury bonds to convert their bonds into gold were also revoked (many commentators have implied this action to be a sovereign default by the US).

1931 was the first year in recorded history of the US when both US Treasury Bonds and US Stocks yielded negative returns in the same year. The following two years marked a watershed in the history of the US financial system.

Bretton Wood agreement of 1944, established USD as the reserve currency of the world. The agreement, inter alia, provided that all the participating nations would allow free conversion of their own currencies into USD at all times; and the US will allow conversion of USD into gold at a fixed exchange rate of USD35 per troy ounce of gold. At that time the US manufactured over half of the total global production, as most of Europe and Japan lay shattered due to WWII. Obviously no one objected to the reserve currency status of the USD.

In the next 25yrs, Germany and Japan made substantial progress. The US share in global GDP fell from 35% to 27% during 1950-1969. The US participation in the Vietnam war (1964-1970) took a significant toll on the US economy. Besides, other political efforts like “Great Society” etc., also weakened the US economy. The “reserve USD” became highly overvalued, impacting US exports and causing a sharp rise in trade deficit. The US was forced to print more USD to keep its obligation under the Bretton Wood agreement. This led to a sharp decline in the gold coverage ratio of the USD. The inflation also shot up sharply.

To stem the run on US banks, the Fed had increased its key policy rate to 9.75% by October 1969.

1969 was the second time in recorded history of the US when both US Treasury Bonds and US Stocks yielded negative returns in the same year. Two years later, in August 1971, president Nixon unilaterally abandoned USD peg to gold, hence rescinding the 27yr old Bretton Wood agreement. For other participants in the agreement, it was a virtual default on the part of the US. However, the advent of “petro dollar” a few years later sustained the reserve currency status of USD.

Presently, the USD is arguably highly overvalued. The Fed is hiking rates and reducing money supply. Inflation is high. The economy is on the verge of recession. Trade deficit is rising. Fiscal deficit is at an unsustainable level. The US share in the global economy is shrinking. Large trade partners of the US, like China, OPEC, Japan, etc. are exploring non-USD trade with other trade partners. The US is incurring huge costs in the Ukraine war. And 2022 is the third time in history when both US treasury bonds and stocks have yielded a negative return in the same year.

If history rhymes, we could see some material developments in the US and, perhaps the global, financial system. A sharp USD devaluation, replacement (or supplement) of USD with a new digital currency, end of petrodollar regime (and hence reserve status of USD) are some of the wild guesses I could make.

The Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) unanimously decided to hike the key bank rate by 50bps to 4.25%-4.5% target range, the highest since 2007. From near zero in the beginning of the year, this is perhaps the sharpest rise in rates in one calendar year.

In the customary post meeting press conference, the Fed chairman Jerome Powell emphasized on the commitment to rein inflation. He said, “we still have some ways to go” and “I wouldn’t see us considering rate cuts until the committee is confident that inflation is moving down to 2% in a sustained way,” indicating that rates will rise in 2023, though not at the same speed as 2022. The Fed chairman reiterated, “It is our judgment today that we are not at a sufficiently restrictive policy stance yet,” adding “We will stay the course until the job is done.”

The Fed Chairman had stated after the November FOMC meeting that the pace of tightening is less significant than the peak and the duration of rates at a high level. The Fed’s latest stance also emphasizes that the markets should brace for “higher for longer”.

The FOMC statement clearly indicated that they are aware that higher rates will impact the economy adversely. The projected unemployment rate for 2023 has been hiked to 4.6% from 3.7% in November 2022, as the economy is forecasted to grow at just 0.5% in 2023, at the same pace as 2022. The Chairman noted, “I wish there were completely painless way to restore price stability. There isn't, and this is the best we can do.”

It would be interesting to see if the Fed can actually deliver a soft landing of the economy as promised, without triggering a deeper recession, while attaining a milder inflation as per the target.

The Fed Chairman welcomed the recent lower inflation prints, but wants more substantial evidence to believe that the inflation is on a sustained downward path. He said, “the inflation data received so far in October and November show a welcome reduction in the pace of price increases, but it will take substantially more evidence to give confidence inflation is on a sustained downward path.” The Fed now expects the personal consumption expenditures price index, currently running at 6% - to cool to 3.1% in the final quarter of next year and to 2.5% by the end of 2024.

Belying the market expectations, the Fed Chairman clearly hinted that the rate hikes will continue in 2023 and the policymakers projected rates now indicate that we may end the next year around 5.1%, slightly higher than the previous projections. The dot plot now indicates a cut of 100bps from 5.1% in 2024.

 The latest policy statement and the aggressive stance of the Fed, is likely to anchor the inflationary expectations while resting the frequent speculations of an imminent “peak” followed by immediate easing of rates.

The equity markets were disappointed as most participants were expecting a “peak” below5% and a cut in 2023 itself. The stock ended lower after a volatile session. The bond markets were however not too bothered and yields ended marginally lower after the Fed statement.

 The Reserve Bank of India (RBI) shall announce the latest monetary policy stance of its Monetary Policy Committee (MPC). While the market narrative is focusing on the decision regarding change in the policy rates, I believe the decision “to hike or not to hike” may not be the primary point of deliberations over the past two days.

In the past seven months since May 2022, RBI has hiked the key policy repo rate by 190bps. The benchmark bond yields or lending rates have not risen in tandem to the policy rates. Only the call money rates and bank deposit rates have seen a corresponding rise. This could mostly be a function of sharp rise in credit growth (now above 18%) at a time when RBI had reversed its accommodative stance and withdrawn over INR12trn of surplus liquidity from the market

The benchmark 10yr treasury yields have fallen 25bps in the past six months. However, 3-6months bond yields have seen sharp rise of 135bps and 112bps respectively.

 

The hike in repo rate has been only partly transmitted to the markets in terms of lending rates. The base rate of banks has risen from 7.25%-8.8% (in the week ending 06 May 2022) to 8.10% - 8.80% (in the week ending 02 December 2022). MCLR of banks has changed from 6.50% - 7.00% to 7.05% - 8.05% during this period. Savings bank rates (Nil change) and small savings rates have hardly moved in this period. However, the bank deposit rates have grown much faster from 5.00-5.6% to 6.1% - 7.25% during this period.

The call money rates have risen from an average of 3% to 5% during this period.

From the above it appears that it is the withdrawal of accommodation (liquidity) that may have impacted the money market rather

The monetary tightening in the past seven months does not appear to have material impact on the price level, which continues to remain elevated, led by energy and food. Of course, the monetary policy measures usually impact the prices with some time lag and we may see the prices correcting going forward.

However, what may worry MPC is that the growth is already showing signs of slowing. Negative real rates on deposits are hurting savings. There is not much evidence of rising rates destroying consumption so far, but we may see it going forward. The global commodities appear to have bottomed and a China reopening is seen as a trigger for rise in commodity prices, despite slowing global growth. The rising external vulnerabilities might keep USDINR under pressure, keeping imported inflation high. Obviously, MPC cannot ignore the actions of the Fed and the narrowing gap between India and US risk free yields.

Besides, MPC must have given a roadmap to the government to bring inflation within its tolerance band of 4-6% last month. The statement today might echo the commitments made in the letter written to the government last month.

So, MPC would have deliberated how to find equilibrium between liquidity, inflation, growth, external stability (Fx reserve, flows, USDINR, export competitiveness), financial stability and also political expediency.

 The minutes of the last meeting of the Federal Open Market Committee (FOMC) of the US Federal Reserve System (Fed), held in November 2022, were released a couple of days ago. The meeting was a joint meeting of the FOMC and the Board of Governors of the Fed, hence the number of participants were much larger than a usual FOMC meeting.

After the release of the minutes, the popular media narrative has been that the Fed officials and most participants are concerned about the likely adverse impact rate increases could have on financial stability and the economy; hence, we could “soon” see the Fed scaling down the pace of rate increases. The markets have obviously drawn a sense of comfort from this narrative and decided to move higher.

The minutes make some points that I found worth noting. From a plain reading of the minutes, I find that the participants were generally—

(a)   Surprised by the resilience of the job market;

(b)   Concerned about the persistence of the inflation and assessed the risk on the upside;

(c)    Comfortable with the broad economic conditions which are presently indicating slower growth but no risk of recession;

(d)   Comfortable with the anchored inflationary expectations;

(e)    Confident that the monetary tightening will reflect on inflation and other economic conditions with a time lag;

(f)    Inclined to keep the monetary policy “restrictive” for long;

(g)    Focused on the final Fed rate that would be adequately restrictive, rather than the rate hiked per meeting; and

(h)   Mindful of the market expectations and behaviour about the monetary policy direction and trajectory.

The media narrative of a slower pace of hikes (50bps in December meeting), seems to be driven by the following five mentions in the FOMC minutes:

1.    The minutes noted that “Most respondents to the Open Market Desk’s surveys viewed a 50 basis point increase in the target range for the federal funds rate at the December meeting as the most likely outcome.”

2.    “A number of participants observed that, as monetary policy approached a stance that was sufficiently restrictive to achieve the Committee’s goals, it would become appropriate to slow the pace of increase in the target range for the federal funds rate. In addition, a substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate. A slower pace in these circumstances would better allow the Committee to assess progress toward its goals of maximum employment and price stability. The uncertain lags and magnitudes associated with the effects of monetary policy actions on economic activity and inflation were among the reasons cited regarding why such an assessment was important.”

3.    “A few participants commented that slowing the pace of increase could reduce the risk of instability in the financial system.”

4.    “Some participants observed that there had been an increase in the risk that the cumulative policy restraint would exceed what was required to bring inflation back to 2 percent. Several participants commented that continued rapid policy tightening increased the risk of instability or dislocations in the financial system.”

5.    “There was wide agreement that heightened uncertainty regarding the outlooks for both inflation and real activity underscored the importance of taking into account the cumulative tightening of monetary policy, the lags with which monetary policy affected economic activity and inflation, and economic and financial developments.”

Interestingly, the media narrative generally ignored the following noting, that indicate lack of consensus on slowing the pace of hikes:

A.    “A few other participants noted that, before slowing the pace of policy rate increases, it could be advantageous to wait until the stance of policy was more clearly in restrictive territory and there were more concrete signs that inflation pressures were receding significantly.”

B.    “With monetary policy approaching a sufficiently restrictive stance, participants emphasized that the level to which the Committee ultimately raised the target range for the federal funds rate, and the evolution of the policy stance thereafter, had become more important considerations for achieving the Committee’s goals than the pace of further increases in the target range. Participants agreed that communicating this distinction to the public was important in order to reinforce the Committee’s strong commitment to returning inflation to the 2 percent objective.”

C.    “Members agreed that, in assessing the appropriate stance of monetary policy, they would continue to monitor the implications of incoming information for the economic outlook. They would be prepared to adjust the stance of monetary policy as appropriate if risks emerged that could impede the attainment of the Committee’s goals. Members agreed that their assessments will take into account a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments.”

D.    “Russia’s war against Ukraine is causing tremendous human and economic hardship. The war and related events are creating additional upward pressure on inflation and are weighing on global economic activity. The Committee is highly attentive to inflation risks.”

In my view, the chances are high that the Fed may slow the pace of hikes from the December meeting; but the end rate may be higher than previously estimated. We may have decisively shifted to “higher for longer” from “lower for longer” rate scenario.

More on FOMC minutes next week.

 The toughest job in the present day environment is risk management. Of course, it has never been an easy job; but when we consider the proportion of moving parts, fragility of systems, disregard for conventions, total lack of mutual trust and disillusionment with the status quo, managing risk appears the toughest job. I can now appreciate the risk managers’ plight during the first half of 20^th century; when similar conditions were prevailing.

To illustrate my point, let me highlight the following instances which may not appear ominous to a common man, but could give cold sweat to risk managers.

• Interest rates have risen in most parts of the world in the past one year. In many cases the rise in rates has been rather steep, especially the developed economies. Most of these economies were struggling with deflation pressures for the better part of the past two decades. Obviously the rates were low (close to zero and negative in many cases). Many businesses were built assuming this to be a lasting phenomenon; or at least many investors valued businesses assuming this to be a lasting phenomenon. The pandemic however annulled this assumption. It now appears that we shall not have near zero rates for longer, even if inflationary pressures ease in the next couple of years. A large number of the businesses built on “lower for longer” assumptions are facing existential risk.

How would a risk manager handle this risk? If an investor changes the assumption of “lower for longer”, the basic case for investment in such ventures may collapse. An exodus that may thus result would only result in immediate collapse of such a venture. If the management guides change in assumptions about finance cost, cash losses and poor visibility of fresh capital, the valuations will collapse anyways.

·         The news flow in the past few days includes the following headlines:

1. “Iran fires missiles at Kurdish militias in eastern Iraq” (see here). This was to follow up 73 ballistic missiles fired by Iran in September 2022 (see here).
2. “Texas to send military armored personnel carriers to the border to escalate enforcement. The move comes days after Texas Gov. Greg Abbott invoked an 'invasion' clause to step up border enforcement.” This is part of the border reinforcement in the past 2 decades in which billions of dollars have been spent. State funding for border security has grown from $110 million in 2008-2009 to nearly $3 billion for the 2022-2023 budget cycle. (see here)
3. “Ukraine nuclear plant shelled, U.N. warns: 'You're playing with fire!” (see here)
4. “South hits back as North Korea fires most missiles in a day.” (see here)

Besides, news flow on Sino-Indian border tensions and China’s aggressive posturing on Taiwan has been consistent. A risk manager who is aware of the energy crisis of the 1970s; has been struggling to manage the fall outs of Russian invasion of Ukraine; and is aware of hardliners winning elections in Italy, Israel, Brazil etc. would find it hard to ignore these geopolitical threats.

• “Mumbai sees temperature dip, IMD issues cold wave warning for parts of Maharashtra.” (see here) This could be a worrying signal for risk managers worrying about inflation; supply of grapes, onions, pomegranates; public health etc.

Besides, in the mountains it started snowing earlier this year. Late rains have ensured late sowing for Rabi crops. If winter sets in early and nascent crops are hit by frost, we may have poor Rabi yield.

• I recently met with a company which earns substantial revenue from UN tenders. The management highlighted the substantial cut in funding of the UN as a key risk to their operations. They did not mind discussing the probability of the UN becoming redundant or even getting dissolved in the next 10-12 years.

The point I am trying to make is that in the present times investors should better avoid overconfidence in any investment idea. The black swans could emerge in flocks from nowhere. It is therefore a good idea to keep portfolios well diversified and liquid. Exposure to exotic, unproven, experimental, innovative, expensively valued businesses must be kept to bare minimum – ideally not more than what you could easily afford to write down fully.