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
