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The focus of financial markets is now on the major economies and monetary policy decisions of their central banks. Economic uncertainty is rife and financial markets remain volatile. What are the causes of this macro-financial volatility, their channels of spillovers into India, the impact on domestic activity and markets and the likely influence on the Monetary Policy Committee’s (MPC) thinking and actions in the future?
Sticky inflation and tepid growth outlook have put global central banks in a spot. RBI could look at a rate cut
The policy mistake of 2021 is still too searingly vivid in central banks’ memories. After spending all of 2021 considering inflation as “transitory” and delaying policy tightening, the inflationary surge after the Ukraine crisis forced all global central banks into synchronised rate hikes at an unprecedented pace. The global economy is now at a juncture where growth momentum is clearly slowing, but inflation remains persistently sticky. From double digits in mid-2022, inflation in most developed countries has fallen to sub-3.0%, but the pace of “last mile” disinflation is proving tricky, with services inflation in particular remaining elevated.
While wary of keeping interest rates high for too long and risk tipping economies into recession, they are equally concerned about a policy mistake of prematurely cutting rates leading to a resurgence of inflation
Global central banks have a dilemma. While wary of keeping interest rates high for too long and risk tipping economies into recession, they are equally concerned about a policy mistake of prematurely cutting rates leading to a resurgence of inflation. A resurgence, among other consequences, might necessitate a pivot away from rate cuts back into a rate hike cycle. The already dented credibility of central banks might also force them to hike more aggressively, in the pivot, than might otherwise be warranted.
Everything, everywhere, all at once
Nowhere is this dilemma more stark than in the US. Multiple data releases have sequentially painted a mixed, even conflicting, picture of the resilience of the economy. At August beginning, weaker than expected jobs data led to a large re-rating of US “soft landing” prospects to a recession. Markets shifted their earlier shallow Fed rate cuts expectations to much deeper cuts in 2024 and 2025. This was then reinforced by lower July CPI and wholesale inflation.
If this economic uncertainty was not enough, central banks have had to contend with a spike in financial markets volatility
The Fed Funds Rate at 5.35% implies that’s a real policy rate of over 2.4%, considered overly tight at this stage of the growth cycle. However, lower jobless claims for two weeks in a row has again shifted the narrative to continuing resilience in labour markets. US Fed Chair Jerome Powell’s comments at the Jackson Hole conclave are eagerly anticipated.
In comparison, economic weakness in the Euro area is much more evident, but even here, uncertainty about last mile inflation keeps the European Central Bank unable to signal its future rate cut path.
Heightened geopolitical tensions in the Middle East completed the trifecta. The US Dollar saw large swings, affecting global foreign exchange markets
If this economic uncertainty was not enough, central banks have had to contend with a spike in financial markets volatility. August saw an unusual convergence of shocks roiling global markets. The US employment data jolt was followed by an unexpected hike in the policy rate by the Bank of Japan, accompanied by a hawkish commentary by the Governor, resulting in a sharp appreciation of the Yen-Dollar exchange rate. This led to a rapid unwinding of “carry trades” in the Japanese Yen (borrowing Yen cheap to invest in higher interest rate countries), affecting global equities markets. China added to this with an unexpected cut in its key policy rate. Heightened geopolitical tensions in the Middle East completed the trifecta. The US Dollar saw large swings, affecting global foreign exchange markets.
How will this influence MPC decisions?
The spillover of this volatility into emerging markets including India was inevitable. The Rupee had already begun to depreciate since mid-July, falling from 83.50 to 83.73 to the US Dollar at end-July, and then close to 84 by 8 August. The proximate reason was large outflows from equity markets by Foreign Portfolio Investors (FPIs), due to a flight to “safe haven” currencies.
A global slowdown in economic activity will affect trade, hurting our exports
The “Impossible Trinity of Open Economy Macroeconomics” hypothesis states that with free capital flows and flexible exchange rates, the task of central banks in setting interest rates at levels appropriate for moderate domestic inflation and supporting growth becomes complicated. For instance, while still resilient, there are early signs of slowing growth momentum. This suggests a need to boost economic growth by gradually lowering interest rates, particularly given the low “core” CPI inflation.
While financial markets volatility is likely to be transient, the longer-term impacts will persist through multiple channels. Investor caution might impede longer term investment commitments, affecting FDI capital. A global slowdown in economic activity will affect trade, hurting our exports. This will also adversely affect overseas Indians remittances. Finally, global demand will determine commodities, metals and energy prices, which will have a big impact on India, a large importer.
Yet, any easing – or even signals of easing – will lead to a further depreciation of the Rupee, aggravating fears of higher imported inflation, and other economic frictions further reducing growth. The Governor’s statement post the recent MPC review acknowledged the influence of global developments on India’s policy decisions but seemed relatively downplayed.
Yet, any easing – or even signals of easing – will lead to a further depreciation of the Rupee, aggravating fears of higher imported inflation, and other economic frictions further reducing growth
One beneficial outcome, despite this policy constraint, emanating from fears of a global slowdown is that financial markets have already done part of the MPC’s job. “Financial Conditions” have eased. For instance, the benchmark 10-year India government bond yield has dropped from 7.1% pre-budget to 6.9% post, now down to 6.87%, the Rupee has weakened to close at 84 and equity markets have corrected to more reasonable valuations.
The biggest challenge in MPC’s monetary policy response is a calculated risk that early interest rates cuts, to boost India’s growth amidst global uncertainty, might potentially re-ignite inflation. Given the likely future growth–inflation tradeoffs, this maybe a risk worth taking.