Vijay Kumar Gaba

 The Monetary Policy Committee (MPC) is currently holding its bi-monthly meeting. This particular MPC meeting is perhaps one of the least discussed by the market participants. There is not much anticipation about the outcome that will be known tomorrow morning. The consensus overwhelmingly believes that RBI will maintain the status quo on rates and monetary policy stance.

A quick reference to a note prepared by the research team of the State Bank of India would be apt to highlight the extent of the lack of excitement amongst market participants over this MPC meet. The SBI team devoted three full pages to verify a humorous US study that correlates the height of Fed chairman to the rate hikes and discovered that incidentally it is true in the case of India also.

Though the market is divided in its expectation about the course of action the Federal Open Market Committee (FOMC) of the Federal Reserve of the US would take in their meeting scheduled on 13-14 June 2023; few expect a 25bps hike by the Fed would have any bearing on the RBI decision making. To that extent RBI policy making effort may have already diverged from the developed market central bankers, particularly the US Federal Reserve.

The reasons for this divergence in the direction of monetary policy are obvious – strong growth data; inflation within tolerance range; stable bonds and currency markets; comfortable liquidity; positive foreign flows; much improved current account; and better than expected corporate performance. Specter of an erratic monsoon is definitely a red flag; but it may influence the timing to begin easing the monetary policy rather than the decision to maintain the status quo. 

I find it interesting to note that economists are not bothered to mention the probability of the MPC to consider accelerated tightening due to heating of economy, especially given the GDP growth has outpaced RBI’s own much above consensus forecast; spike in unsecured personal loans; and sharp rise in real estate prices in most urban and semi urban pockets.

Like market participants, I am not eagerly waiting to hear what the governor Das has to say on the MPC decision tomorrow morning. Nonetheless, I would be keenly watching if the RBI takes some precautionary steps to check unsecured personal loans and credit to the real estate market. I am also not keen to look for a hint of rate cut in the August meeting, though the real rates are now in the territory where these could constrict growth.

From various recurring events that generate significant anticipation and anxiety amongst market participants, the speech of the US Federal Reserve chairman at Jackson Hole annual symposium is the most popular one. This year the speech is scheduled to be delivered on 26^th August. Since, the markets are again filled with anticipation and anxiety. I find it pertinent to highlight a few things about the event and its likely consequences.

Jackson Hole is Davos in Wyoming

Later this week the Fed Chairman Jerome Powell is scheduled to make a speech in a symposium held in Jackson Hole valley (Wyoming, USA). This annual symposium, sponsored by the Federal Reserve of Kansas City, has been held since 1978; and in Jackson Hole since 1981. The symposium is usually held in the month of August, just ahead of the pre scheduled US Federal Reserve Open Market Committee (FOMC) meeting in September.

Many prominent central bankers, finance ministers, reputable academicians and market participants take part in this symposium to discuss the currently important issues facing the global economy. In the distant past, some reputable economists, like James Tobin (Tobin Rule) and John Taylor (Taylor Rule), have presented their path breaking papers at the symposium.

It is customary for the US Fed representative (Usually the Chairman or a senior official) to present their thoughts on the topic selected for that year’s symposium. The topic for the 2022 symposium is “Reassessing Constraints on the Economy and Policy”.

There have been a couple of instances (Paul Walker 1982 and Greenspan 1989) where the US Fed representatives dropped some hints about the imminent policy changes in the ensuing FOMC meetings. But those hints were incidental and not by design. Otherwise, there has been no instance where the thoughts of the US Fed representatives have actually digressed from the given topic for the symposium. Nonetheless, various experts have been regularly conducting a post-mortem of their speeches to find mentions of the words and terms which they can use to market their own views in the garb of the Fed’s hints.

In fact in the past two decades, no path breaking paper has been presented at the symposium and Fed chairman speeches have been noted for all the wrong reasons; most notable being the Bernanke dismissal of sub-prime crisis (2007); and Greenspan’s advocacy for expansionary policies (2005), which was heavily criticised by Raghuram Rajan in 2005 and rest of the world in 2008.

It would therefore be not completely wrong to say that the Jackson Hole event is now mostly irrelevant for the financial markets. A harsher criticism would be to state that Jackson Hole is on the path to become the American version of annual outing of worlds’ elite held by an NGO (World Economic Forum) in Europe’s Davos.

For records, at the last year Jackson Hole symposium, the Fed Chairman did not say or hint anything that had not been said at previous FOMC meetings, Congressional testimonies and various public speeches. The focus was on the topic of the symposium (“Macroeconomic Policy in an Uneven Economy”) rather than the monetary policy of the US Federal Reserve. In fact, to highlight the role of monetary policy in the current macroeconomic environment, Chairman Powell had mentioned that “The period from 1950 through the early 1980s provides two important lessons for managing the risks and uncertainties we face today. The early days of stabilization policy in the 1950s taught monetary policymakers not to attempt to offset what are likely to be temporary fluctuations in inflation. Indeed, responding may do more harm than good, particularly in an era where policy rates are much closer to the effective lower bound even in good times.” (Speech of Fed Chairman Powell at 2021 Jackson Hole Symposium)

Do not rush to fill your buckets

In case an investor is feeling a rush to act in anticipation of what the Chairman Powell might (or might not) say at Jackson Hole this Friday, I would like to narrate the following to him/her:

If a geologist tells you, “the Himalayan Glaciers are melting fast and there will be no water in the Ganges in the year 2050”; what would be your instant reaction? Will you—

·         Rush to store water in buckets?

·         Begin to explore places which are not dependent on the Himalayan Rivers for their water needs, for relocation in next few years?

·         Commit yourself to the environment conservation by adopting 3R (Reduce, Reuse and Recycle) as part of your life so that the green house emission is reduced, global warming is reversed and the geologists are proven wrong?

·         Dismiss the information provided by the Geologist as fait accompli and get on with your routine life?

I may say with confidence that various people will react differently to this information, but none will rush to store water in buckets, and a very large majority will dismiss the information as fait accompli.

I believe that the finance and economics experts prophesying various policy changes are no different than the Geologist forecasting the end of the Himalayan glaciers; and the investors’ collective reaction to their prophecies is also no different. A large majority of investors dismiss the experts’ views and perhaps no one takes material investment decisions based on these prophecies. Nonetheless, these prophecies do create an environment of great anticipation with usual jitteriness and eagerness in the near term. One mistake most of the investor make in this environment of jitteriness and eagerness to do something, is to not ask themselves—

(a)   What is the situation that is being sought to change?

(b)   How the change would impact the businesses underlying their portfolio of investments?

(c)    How the action they are contemplating to take will protect them from the perceived adverse impact of the change in the status quo?

For example, if Quantitative Tightening (QT) is prompting you to take an action on your portfolio – look at the following US Money Supply chart (M2) chart and decide how long will it take for the US Money Supply to reach pre QE1 level.

 Hikes another 75bps

The Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) hiked the federal fund rate by 75bps yesterday to the range of 2.25% - 2.50%. This is the second 75bps hike in two months. In the post meeting press interaction the Fed chairman Jerome Powell outrightly rejected the speculations that the US economy is in recession. The FOMC members are of the opinion that the strong labor market allows the US economy to tolerate rapid monetary tightening.

For the first time since February 2020, the FOMC statement did not mention Covid or coronavirus.

…leaves the door open for further data dependent hikes

Reiterating the commitment to achieve the 2% inflation target, Powell also indicated that while another unusually large increase could be appropriate at our next meeting, the FOMC would set policy on a meeting-by-meeting basis rather than offer explicit guidance on the size of their next rate move, as he has done recently; thus, leaving the future course of the FOMC action wide open.

As per the Bloomberg estimates, the market consensus is now gathering around two more 50bps hikes in September and December FOMC meetings, with the fed fund rate peeking around 3.4%, lower than the previously estimated 3.8%.

The US economy is estimated to have grown at a tepid 0.4% (QoQ, annualized) rate in 2Q2022 after recording a negative growth in 1Q2022, technically avoiding a recession. The US officially acknowledges a recession if the economy logs a negative growth for two consecutive quarters.

Markets react positively to FOMC – stock rally, yields and USD tumble

The markets took comfort from the growth outlook and Powell’s statement on future rates being data dependent. The market participants appear to have concluded that the FOMC may reach the end of the tightening cycle by the end of 2022, triggering a “risk on” rally in the markets.

·         Battered tech stocks surged strongly with the benchmark Nasdaq rising 4.06%, the largest one day gain since November 2020. The broader index S&P500 gained 2.62%.

·         US Dollar Index lost 0.66%.

·         2yr SU Treasury yields fell 10bps; while 10yr benchmark yields were down 5bps at 2.78%.

…but deeper yield curve inversion signals recession as consensus

The US yield curve is now inverted the most in two decades, highlighting that the markets strongly believe a recession is around the corner. The 2yr yields are now over 30bps lower than the benchmark 10yr yields – clearly indicating that the market sees higher risk of recession than the Fed. The deeper yield curve inversion is seen to imply that Fed may actually return to the path of easing as early as 2023.

Click here to see a nice compilation of analysts’ reactions to the FOMC statement.

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.

Long Covid, is a term commonly used to describe the lingering adverse health effects of the Covid infection. Another dimension of Long Covid is the lingering socio-economic impacts of the pandemic. While only a small percentage of persons who suffered from the Covid infection are showing medical signs of the Long Covid; the socio-economic milieu of almost every country in the world is suffering from Long Covid.

The pandemic has definitely widened and deepened the socio-economic economic divide across jurisdiction. A significant proportion of the population that was pulled out of the abysmal poverty in the past two decades has slipped back below the poverty line. Accelerated digitalization of social services like education and health has deprived many underprivileged children.

To mitigate the sufferings caused by the pandemic, most governments provided monetary and fiscal stimulus to the poor and small businesses. The stimulus checks (and ration and medicine kits) created artificial demand for two years. This happened when the supply chains were broken across the product lines.

It is pertinent to note that ever since the global financial crisis (2008-09) the investment in new capacities in commodities (mining, metals, coal, oil & gas etc.) was dwindling, while the money to build leveraged positions in commodities was available in abundance and at extremely cheap rates. We had seen a glimpse of these positions on 15^th April 2020 when the WTI Crude Oil Futures settled at negative $37.4/bbl.

Some of the highlights of the socio-economic dimension of Long Covid are as follows:

1.    The sudden and exacerbated demand supply mismatch has caused prices of all commodities, including food, to rise sharply higher. The poor are obviously suffering the most.

2.    The modern monetary theory (MMT) that was working just fine since 2009 seems to be becoming ineffective.

The deluge of new money created since the global financial crisis did not result in any inflation as the new money was not flowing to the end consumers. The new money was mostly adding to the reserves of the banks as the lending standards were made very strict. The credit was mostly flowing to the rich and affluent for investing in financial assets; or it was used for circular trade in government securities to repress the bond yields. Consequently, bonds worth trillions of dollars traded at negative yields; the government borrowed profligately to keep the Ponzi scheme running.

The pandemic has however taken the tide down and exposed the true status of economies, governments and central bankers. The central bankers are now running for cover (withdrawing excess money from the system and hiking rates); governments are focusing on raising revenue (taxes) and distracting the attention of common people to war hysteria & political instability; and economies are slithering into recession.

3.    The stimulus checks, concessional loans and relaxation in lending standards during the pandemic resulted in billions of dollars flowing into the pockets of consumers, like a high dose of life saving steroids. The treatment proved effective and saved millions of lives. However, the effect of steroids has now dissipated. The consumers are struggling with the side effects. Widespread civil unrest, even in the most peaceful jurisdictions like Sweden, and aggression are the consequences.

4.    US consumers are now struggling with 4 decade high inflation, when the mortgage payments are rising as the Fed is getting ready to aggressively tighten. The action of the US Fed, which is preparing to hike another 50bps next month, may not result in any improvement on the supply side. It may however destroy demand and hence bring equilibrium in the markets.

5.    Many emerging markets are now struggling to honor their debt and control inflation to protect consumers. Thankfully the markets are not panicking over Sri Lanka’s default like they did at the time of Greece’s potential default. But if some larger countries join the list of defaulters, markets may react badly.

As I noted a few days ago, for now Mr. Bond is in the driver seat and yields will be driving the global markets. Interestingly, the current generation of investors, traders and money managers have never seen a bear market in bonds. The last bear market in bonds was two decades ago in the early 2000s. It is safe to assume that those below the age of 42-43yrs came out of college after that. Their skills will be tested now.

Even in the equity market, the bear markets of 2008-09, and 2020 were mostly panic driven and recoveries were faster. A pure economic cycle led bear market in equities has not happened since 2003. “IF” the central bankers fail to tame the inflation tiger in the next 6-9 months, we may see an excruciating bear market in equities that will test the skills (especially patience) of investors and traders.

There is an old Chinese curse which says, “May he live in interesting times”. Like everyone else I also do not wish to live in interesting times. But then the world does not function as per my wishes. I must therefore prepare better for the adversities and the opportunities that will follow.

This world is like a prism. You see different pictures, colours and hues depending upon from which angle and under what light you are viewing the world. Therefore, while all views and colours are equally valid, your "truth" is always what you see from the point you are standing at a given point in time and under the current light.

In the past few months, inflation has become one of the driving narratives of monetary policy world over. From Brazil to Britain, and Australia to the Eurozone, the central bankers have expressed concerns over rising prices. Over 30 central banks have actually raised policy rates in the past 12months to control inflation. The US Fed is also widely expected to embark on a path to accelerated rate hike from next month onward.

Insofar as the monetary policy impact on inflation is concerned, in my view, in the latest episode, inflation (rate of increase in the prices) is not the only problem. It is the current price level that is hurting people severely. Hikes in rates will only curtail demand. This may not necessarily bring down the prices. The effort needs to either increase the income of common people or materially augment the supply of essential goods to bring down the prices from the current levels.

I have spoken to a number of people from various sections of society in the past one month to understand how inflation affects their lives. Not surprisingly, all of them had different perceptions about inflation. Obviously, they all view the issue from their own angle and under the light of their own circumstances. If I could extrapolate the feedback of these people—

(a)   For almost half the population, primarily living in rural areas, ideally food inflation ought not be a matter of concern. A farmer should gain maximum from the food inflation. Given that over 60% of the population is engaged in the farming and related activities, theoretically consistently high food inflation should result in transfer of wealth from non-farm sector to the farm sector. But this has not been the case in any of the high food inflation episodes in the past seven decades. The gap between rural and non-rural income and wealth has been consistently widening.

The reasons could be un-remunerative prices for the crop and higher than food inflation in healthcare, agri input, energy and transportation.

(b)   Urban, semi-urban households suffer from a variety of inflation. Prominent amongst these are education, health, energy, transportation, communication, rental, protein, fruit and vegetable. The political rhetoric and central banker's focus exclude many of these critical elements in their fight against inflation. Lack of good public healthcare, education and transport services, energy efficiency, affordable housing, and better employment opportunities closer to home is hurting this class the most.

The expense on food for a typical Indian middle class family is about 30-40% of their income. A typical middle class household saves 20% of his income. If food inflation is 10%, a 3-4% rise in nominal income would be needed to offset that. Besides, they would need sufficient rise in nominal income and asset prices and interest rates to offset the erosion in real value of their savings. This perhaps has not happened in the past many decades, implying that the nominal rise in asset prices and interest rates have not been consistent with the general rise in price levels. The wealth is thus consistently getting transferred from savers to borrowers.

(c)    Debt laden infra and realty developers are more concerned with inflated cost of capital and wage inflation. Energy and transportation costs also bothers them. This section needs better execution standards, simpler administrative procedures, automation, good corporate governance structure, stricter compliance norms and a vibrant retail debt market to alleviate the problems they face. Vegetable and edible oil prices do not bother them much.

One could argue that transfer of wealth from farmers and the urban middle classes to traders & indebted industrialists is a function of risk they take. But if we consider the history of NPA cycles, and exploits by moneylenders this argument gets weaker. Large borrowers have been consistently transferring the risk to public sector banks, and hence the common public, through frequent defaults. The money lenders in the informal sector have been fairly successful in exploiting the household and farmer borrowers, not allowing any benefit of inflation to them.

Actually, maintaining the negative real rates for households (household inflation minus term deposit rate) for a long period is the biggest scam perpetrated on the poor people of this country. The inflation tax, as I call it, paid by poor and middle class savers for cheaper financing of “crony socialism” and unscrupulous businessmen, has after all caused serious damage to the basic fundamentals of the Indian economy.

For a common man like me on the street, who is blissfully ignorant of the principles of economics and public finances, inflation is nothing but an enigma. The rising prices do hit him hard, but that also lead to a rise in his nominal income and hence social stature. Higher nominal interest rate on his savings, higher notional value of his house & jewellery; and higher rental for the spare room on the top floor does provide him some psychological comfort.

For a common man, inflation might be more of an income inequality issue. For many decades, inflation has been a medium of wealth transfer from common man to the rich. The current raging debate over rise in prices of food therefore has to be seen from this angle also.

The weather in the market has changed rather dramatically over the past two weeks. As we changed the calendars about four weeks ago, it was a partially clouded sky, but no one was forecasting a hailstorm, the markets are witnessing for the past 6 trading sessions. Seven odd percent fall in the benchmark Nifty is certainly not indicative of the damage that has been caused to equity investment portfolios, as the theater has been mostly outside the Nifty.

The sharp correction in equity prices is nothing unusual. In fact it has been a regular feature of the markets ever since the advent of public trading of corporate. However, in modern times this volatility assumes a wider socio-economic significance because the markets have become increasingly democratic. The access to the market is no longer confined to an elite section of the society. Investors in listed equities now come from all walks of life – young college students to old pensioners and top metros to the poorest districts of the country.

No surprise, the policy makers afford significant importance to the “markets” and markets also expect undivided attention from the policy makers like a possessive child. The markets begin to throw tantrums if they get any hint of likely coercive or disciplinary action from the policymakers.

Moreover, social media has not only made markets more sensitive to the flow of information; it has also made markets more susceptible to manipulation by vested interests. The market participants are often inundated with incoherent data from across the globe, invoking “fast finger first” type reactions from traders. Robotic traders, which account for a significant part of the market activities these days, often follow the herd and accelerate the prevailing trend.

As per the popular commentary, the market fall in the present instance is precipitated by the following “factors” and/or “fears”:

(a)   The US Federal Reserve (The Fed) is expected to end its bond buying program that was started in 2019, and begin hiking the policy rates from March onwards. It is expected that these Fed policy actions may result in higher bond yields and tighter liquidity leading to unwinding of USD carry trade. This shall lead to outflow of foreign funds from emerging markets that have benefitted from the deluge of liquidity created by central bankers of developed countries.

In this context, it is relevant to note that:

(i)    This move of the Fed is most anticipated since the past many months. The markets are known to act in much advance of these anticipated events and rarely wait till the last minute.

(ii)   The foreign investors have been net sellers in the Indian secondary markets for most of the current financial year. In fact, in the past 13months they have already sold Rs1.1trn worth of equities.

(iii)  The empirical evidence indicates that the Fed rate hike cycles usually lead to higher equity prices.

(iv)   Indian bond yields have already risen sharply over the past six months. Even if the Fed raises 50-75bps over 2022, the yield differential will still be attractive for the foreign investors.

(v)    In 2021, the last action of 17 central banks was a hike in rate, and none reduced. In spite of this, markets made all-time highs across the world.

(b)   There could be a Lehman like collapse or a dotcom like bust in the market.

The global central bankers have learned their lessons well from the global financial crisis. From the Greek sovereign crisis to Evergrande default, there is sufficient evidence to support their ability to mitigate the contagion impact of any major failure.

Insofar as the valuation bubble is concerned, we have already seen 50-70% correction in numerous inflated assets/stocks in the past three months, while global indices were recording new highs every day. The ability of markets to handle sectoral busts is certainly much better than the dotcom era of 2000.

(c)    Hyperinflation is upon us and financial assets will lose their value.

The global experts are still struggling to define whether the current episode of inflation is supply driven or demand pulled. The helicopter money that led to sudden spurt in demand has been largely exhausted. It is paradoxical to assume that no more helicopter money would lead to price erosion in the equity market but continue to fuel inflation in goods markets. The growth has already moderated world over and logistic constraints are not structural enough to last for years. Technology that has been the biggest deflationary force in the world continues to advance.

The traditional inflation hedges like gold have shown no sign of heating in demand. The German and Swiss benchmark yields are still negative and Japanese bonds are witnessing no bear attacks. The Chinese central bank has lowered rates.

(d)   There could be a full-fledged war between Russia and NATO allies.

Neither the conflict at Yatseniuk’s Wall (Russia and Ukraine border) is new; nor is the conflict in Middle East Asia new. The bogeyman of WDM (Weapons of Mass Destruction) in Iraq killed almost every chance of significant united NATO action two decades ago. Russia invaded and annexed Crimean peninsula from Ukraine in 2014. The US and Russian relations have shown no apparent signs of deterioration post that. The German Navy Commander recently revealed the German thoughts on potential Russia-Ukraine conflict.

(e)    The pandemic effects are unknown. The rising inequalities and poverty will plunge the world into chaos.

There is sufficient empirical evidence available to show that the rising inequalities have benefitted the larger companies and therefore stock markets. The world has been a chaotic place for at least the past 2 million years. In fact the past two decades perhaps have been the most peaceful period in the post Christ era.

(f)    The finance minister may impose new taxes in the budget to manage the resources for populist agenda of the government.

The Union Budget actually ceased to be an important event many years ago. Indirect taxes are mostly no longer part of the budget now. Direct taxes are mostly rationalized and have little scope for tinkering. Fiscal data is announced every month and it is easy to estimate the deficit and borrowing figures on a regular basis. Usually there are no negative surprises on this account in the budget.

This time particularly, the finance minister is in no position to cut tax rates and it can hardly afford to hike taxes. There could be some minor tinkering here and there, but nothing major should be expected. The fiscal deficit figure will account for Rs 1trn from LIC IPO, which is not certain. Obviously, assessing the accounting part of the budget may be difficult.

Obviously, the market behavior is not in congruence with the narrative. If the investors were truly fearful about the factors they are talking about, then they must have moved towards the shelter (defensive and deleveraged) from the cyclical. Whereas, in 2022 so far, IT, Pharma, FMCG have been the worst performing sectors and cyclical energy and financials which mostly face the brunt of tightening money cycle have performed the best.

In my view, the markets are fearful because (a) they are feeling guilty about the excessive greed shown towards internet and renewable energy; and (b) a large majority of investors lacking in conviction would have followed the pied pipers rather than making an informed decision about their investments, are falling in the ditch.

In its latest meeting the US Federal Reserve Open Market Committee (FOMC) reiterated its position stated in the last meeting. The Committee maintained status quo on the Fed rate (Repo Rate) and its asset (bond) buying program (US$120bn/month). The limit for single counterparty under reverse repo has been raised to US$160bn from the present US$80bn, allowing the banks to park more money with the Federal Reserve.

The Committee reiterated its stance of last meeting, stating that “If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted”; implying that the FOMC decision on QE continues to be data driven, and the present reading of data guides a gradual unwinding of the monetary stimulus introduced to mitigate the impact of Covid-19 pandemic.

“While no decisions were made, participants generally viewed that so long as the recovery remains on track, a gradual tapering process that concludes around the middle of next year is likely to be appropriate”, the Fed Chairman said in a post meeting conference.

The Chairman also informed that the Committee feels that the Fed is closer to passing the test of “substantial further progress” on employment and inflation. Accordingly, more members now see the first rate hike happening in 2022. It is pertinent to note that in June, when FOMC members last released their economic projections, a slight majority of members had projected rate increase into 2023.

The markets have obviously read what it wanted to in the Fed statement. The bullish response to the Fed statement implies that market is giving more credence to the “slower growth” forecast than the “higher inflation” expectation. The market move post Fed statement implies that the confidence in “November Taper” is much lower given the slowing growth and uncertainties in Chinese markets. Even if the tapering begins in November, the pace may slower than anticipated. Also, the data for the “lift” (rate hike) may not adequate as of now and much more evidence may be required before a concrete lift decision could be taken.

Despite the headline inflation running much higher than the fed target of 2%, FOMC did not appear concerned about price situation. The Chairman repeatedly stressed in his interaction with the press that “he expects price pressures to subside as supply chain factors, goods shortages and unusually high levels of demand return to pre-pandemic levels’; thus reiterating his “transitory” stance on inflation.

Many analysts have related the Fed decision to postpone the question of Tapering to the November meeting, to the debt ceiling fracas in US. “The Fed never makes major changes to policy when there are major unresolved issues in Washington,” said Danielle DiMartino Booth, chief executive of Quill Intelligence. “Between the debt ceiling, budget resolution and potential for a government shutdown, there are plenty of political reasons for the Fed to not change policy.”

In my view, Fed would refrain from taking any decision till the (i) concerns over Covid-19 variants subside materially; (ii) political fracas in US ends amicably; (iii) dust created by Evergrande settles down and (iv) “transitory” nature of inflation is denied. November Taper, if at all happens, would be slow (may be US$10bn/month) and protracted. The rate hike decision is still in the realm of speculation.

In past few weeks we have seen some very interesting debates over the prospects of inflation forcing central bankers to change the course of ultra-loose monetary policy and thus derailing the global recovery. There have been strong arguments on both the sides. However, the debate seems to be still inconclusive. There are many reasons for strong disagreements. For one, the debate suffers from historical prejudices and does not completely factors in the fast changing demographic and technological factors. It may also not be fully accounting for the fast evolving sustainability concerns and consequent changes in the global trade and commerce.

Nonetheless, I still find it pertinent to take note of divergent views on the expected trajectory of inflation. Recently, two reputable experts Martin Wolf (Financial Times) and David Rosenberg (Rosenberg Research) published their views on inflation expectations. Both the experts are widely recognized for their biases, and these mutually divergent views do suffer from these biases. Regardless, these views are significantly educating and worth taking note of.

David Rosenberg

The argument that Money supply against money velocity is not leading right now to an inflationary conclusion may not be well founded. Look at wages. Look at all these companies announcing wage increases. After Trump cut taxes on the corporate side and allowed companies to repatriate tax free their earnings from abroad back home and all these companies, 4% of the corporate sector announced wage and bonus increases back in early 2018, some bellwether companies too. So where was the big inflation coming out of that?

Rosenberg essentially agrees with Fed Chairman Jerome Powell that the recent acceleration in inflation seen in April will be temporary. He opines that “What's going on isn't a fundamental "regime shift", but rather a "pendulum" swinging back to the opposite extreme following the sudden deflationary demand shock caused by the pandemic.”

The factors that contributed to this surge in prices are already starting to fade. Commodity prices are falling back to earth, supply chain shortages are slowly being addressed, and leading indicators already show a dramatic increase in exports out of Korea and Taiwan, critical sources of semiconductors. Meanwhile, container ships that are "filled to the brim" are lingering outside the ports of LA and Long Beach, the two busiest ports in the country, as COVID concerns continue to delay the unloading of these ships. With all these signs that supply chain snarls are quickly being worked out, to suggest that the supply will not come back to me is ridiculous.

On the demand side of the equation, federal stimulus has created a sugar high that will wear off by the fall. Around that time, all the workers being kept out of the labor pool by generous government benefits will be forced to look for work again, and the "fiscal withdrawal" will emerge to suppress aggregate demand just as supply levels are normalizing. The fiscal policy and the short term nature of the stimulus has just accentuated the volatility in the data. So, come the fall, we will start to see the re-openings having a positive impact on aggregate supply at a time when we shall see fiscal withdrawal having a downward impact on demand. And so a lot of the inflation seen today is going to reverse course either by late summer or early fall.

Last week, data indicated that productivity is running over a 4% annual rate. Not clear if it is a secular or structural change. But one thing is clear that in the weakest year for the US economy since 1946, it was the best year for productivity in a decade. The corporate sector actually had its best productivity performance in a decade in the same year that we had the worst year for employment since the 1930s.

The TIPS market shows that most inflation expectations being priced in are still "very near term", and that spreads between twos and fives, fives and tens, and twos and 30s shows there's been "no big outbreak of longer term inflation expectations.

They're just telling you that right now we have a tremendous dislocation. And yes, it's going to probably gonna last a few more months. It's not just your base effects. There is some real price increases coming into the fore. But what would you expect? We just had a 10% increase in airfares and the CPI index, they're still down 20% from where they were pre-COVID. You know, the sports tickets and the like that were up 10% in April. You know they're down significantly for where they were pre-COVID. And so there's still tremendous amount of distortions.

(With inputs from www.zerohedge.com . Read the full interview of David Rosenberg here)

Martin Wolf

Milton Friedman said that “inflation is always and everywhere a monetary phenomenon”. This is wrong: inflation is always and everywhere a political phenomenon. The question is whether societies want low inflation. It is reasonable to doubt this today. It is also reasonable to doubt whether the disinflationary forces of the past three decades are now at work so strongly. It is hard to believe these emergency monetary policies should continue for years, as many at the Fed think. I doubt whether they should continue even now.

The jump in US annual consumer price inflation to 4.2 per cent reported last week was a shock. But was it a good reason to panic?

Goldman Sachs notes that the proximate causes of that jump lie in travel and related services, where prices are rebounding from depressed levels, and in some goods, where a post-pandemic surge in demand has run into temporary shortages and bottlenecks.

The Commodity prices have jumped upwards. But prices are not that high by historical standards and are well below past peaks.

Meanwhile, the “break-even rate” — the difference between the yield on conventional and inflation-indexed US Treasuries — has risen sharply, though still to only 2.5 per cent over 10 years. This indicates a rise in inflation expectations and concern over the risks of inflation. Bloomberg’s John Authers notes that forecasts by consumers and professional forecasters have also risen, with the former expecting close to 6 per cent inflation and the latter 3 per cent over the next year.

Both monetary and fiscal policy settings are, by historical standards, wildly expansionary, with near-zero interest rates, exceptional monetary growth and huge fiscal deficits, even though the IMF suggests that the US economy will be operating above potential this year.

There is a large overhang of private savings waiting to be spent and surely a great desire to get back to normal life. Maybe, these will not be the “roaring 2020s”. But they might be far more economically dynamic than most suppose.

While I understand why the Fed changed its monetary framework, I am unpersuaded it was a good idea. It means driving while looking into the rear-view mirror. It would surely be better to learn from past experience how the economy works than to try to compensate directly for historic failures. In particular, the new framework creates uncertainty over how the Fed intends to make up for the past shortfalls.

The politics have changed. One would have to be at least 60 years old to have experienced high inflation and subsequent disinflation as an adult. The government and substantial swaths of the private sector have huge debt liabilities and borrowing plans. Joe Biden’s administration is determined to ensure that this recovery does not repeat the disappointment of the previous one. The stock market is more than generously priced by historical standards, with bubble phenomena everywhere. The doctrines of “modern monetary theory” are highly influential, as well. All this together has strengthened lobbies for cheap money and big fiscal deficits, and weakened ones for prudence.

Given all this, doubts about the Fed are reasonable. We know that it is politically easier to loosen than tighten monetary policy. Right now, the latter is going to be particularly unpopular. Yet if a central bank does not take away the punch bowl before the party gets going, it has to take it away from people who have become addicted to it. That is painful: it takes a Paul Volcker.

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US Federal Reserve Chairman Jerome Powell tried to set many speculations aside in his statement post the recent meeting of the Federal Open Market Committee (FOMC), Powell made the following three things very clear:

1.    US Fed policy Bank Rates, and therefore general rate environment, shall stay low till at least 2023.

2.    There is no threat of material rise in inflation in near term, and 2% inflation target shall remain valid till 2023. Even a temporary violation of 2% inflation target before 2023 shall not impact the decision to keep rates near zero till 2023.

This is in sharp contrast to the forecasts made by many global strategists, economists and fund managers, who believe that inflation could become a serious problem in 2021-22. In fact Powell expressed his concerns about the disinflationary pressures persisting.

3.    The job market is expected to improve and below trend unemployment rate of 4% shall be achieved by 2023.

The Federal Reserve however refrained from announcing any additional liquidity enhancement measures, including increasing the bond buying.

The consensus is reading the Federal Reserve's latest policy statement to mean that (a)   USD weakness may persist for some more time at least; (b) The market may continue to drive the Federal Reserve's action insofar as the monetary support (bond or stock buying etc) is concerned; (c) Powell backstop is there but may not be as strong as Draghi backstop.

This long term guidance by Fed must comfort markets and fuel the risk appetite of market participants. I would not like to read too much into the sell-off in markets post the Powell comments. It might be due to unwinding of the positions taken specifically for this event. No announcement related to enhancing Fed's asset purchase program may have disappointed many who were expecting Powell to announce this. But this is most likely a knee jerk reaction.

In this context, the recent statement of RBI Governor Shaktikanta Das is pertinent to note. Addressing to the National Executive Committee of FICCI, Das emphasized as follows:

"On the back of large policy stimulus and indications of the hesitant economic recovery, global financial markets have turned upbeat. Equity markets in both advanced and emerging market economies have bounced back, scaling new peaks after the ‘COVID crash’ in February-March. Bond yields have hardened in advanced economies on improvement in risk appetite, fuelling shift in investor’s preferences towards riskier assets. Portfolio flows to EMEs have resumed, and this has pushed up EME currencies, aided also by the US dollar’s weakness following the Fed’s recent communication on pursuing an average inflation target. Gold prices moderated after reaching an all-time high in the first week of August 2020 on prospects of economic recovery.

Financial market conditions in India have eased significantly across segments in response to the frontloaded cuts in the policy repo rate and large system-wide as well as targeted infusion of liquidity by the RBI. Despite substantial increase in the borrowing programme of the Government, persistently large surplus liquidity conditions have ensured non-disruptive mobilisation of resources at the lowest borrowing costs in a decade. In August 2020, the yield on 10-year G-sec benchmark surged by 35 basis points amidst concerns over inflation and further increase in supply of government papers. Following the RBI’s announcement of special open market operations (OMOs) and other measures to restore orderly functioning of the G-sec market, bond yields have softened and traded in a narrow range in September."

The governor was very guarded in his outlook for the economy. he stated, "high frequency indicators of agricultural activity, the purchasing managing index (PMI) for manufacturing and private estimates for unemployment point to some stabilisation of economic activity in Q2, while contractions in several sectors are also easing. The recovery is, however, not yet fully entrenched and moreover, in some sectors, upticks in June and July appear to be levelling off. By all indications, the recovery is likely to be gradual as efforts towards reopening of the economy are confronted with rising infections. (emphasis supplied)

Obviously, the incumbent governor does not concur with one of his predecessors Dr. C. Rangrajan who appears quite buoyant about the economic recovery in India.

What does it mean for Indian investors?

• Unless there is a Lehman type moment in global markets, the Indian equities may continue to remain supported.

• Precious metal trade should take a hit.

• The bond yields may remain stable, and RBI may maintain yields around current levels even if the food inflation shoots up in next couple of months.

• MPC may maintain status quo on policy rates in its next meeting, while continuing to maintain accommodative stance.

• Economic growth and therefore corporate earnings may not see a sharp recovery even in FY22.