The picturesque town of Sintra in Portugal last week hosted an unusually candid conversation between four of the world’s top central bankers: the US, the eurozone, the UK and Japan. US Federal Reserve Chairman Jerome Powell, Bank of England (BoE) Governor Andrew Bailey, European Central Bank (ECB) President Christine Lagarde and Bank of Japan (BOJ) Governor Kazuo Ueda were at the annual ECB Forum on Central Banking. Everyone except Ueda was in unison and repeating phrases like “relying on data”, “meeting by meeting”, “strong labor market” and “resilient growth”. They were united in claiming that they should continue to work to “get inflation back on target”. Clearly, the BOJ was joining the party from the other end of the inflation-growth spectrum and was on “watch and see” mode.
If one reads between the lines, Powell, Lagarde and Bailey seem to be saying that despite the drop in headline inflation (presumably due to a larger than expected fall in energy prices), they were little more than surprised that That’s how flexible it is. The labor market was in their respective regions. Given this reality, he saw no way to reduce inflation to his target without “prolonged high” rates. The Fed’s dot-plot, which is an indication of Fed members’ thinking, shows short rates rising to 5.6% from the current 5.0% level. (which implies two more rate hikes), first holding steady and then falling.
Powell divided the components of inflation in the US into three ‘sectors’: the goods sector, the housing services sector (which together make up about 50%) and the broad services sector, which makes up the rest. Powell was optimistic about inflation emanating from the goods and housing services sector, as they are already showing signs of price stability or deflation. According to his reading, the US services sector, which forms a significant component of the wage/profit/loss accounts, is only now beginning to show signs of softening. Powell stated several times that for core US inflation to reach its 2% target, policy would need to be restrictive both in terms of magnitude and timing so that the “sticky” parts of inflation could soften. In a startling admission from a central banker, he said this is unlikely to happen until 2025.
The impact of COVID on the macro-economics of the developed markets (DMs) has been tremendous. The lasting effects have come from supply-chain distortions, behavioral changes related to the labor market, and the excessive liquidity and fiscal response to the pandemic. These effects have contributed to inflation on both the supply and demand sides, leaving central bankers with the challenging task of dealing with the unprecedented phenomenon of rising prices.
Within the DM, there are substantial differences in the various structural components of different economies. The pace of monetary policy transmission is different in a well-integrated economy like the US (Croatia became the 20th eurozone country only on January 1 this year) compared to a still-integrated and growing economy like the EU. The speed of policy-transmission is also largely influenced by the ratio of fixed versus variable rate mortgages and their duration. For example, around 85% of mortgages in the UK are fixed rate loan deals with a relatively short term of around 5 years, compared to 96% in the US with a much longer average term. This slows down the transmission process dramatically.
Markets everywhere seem to disagree with central bankers. In the first six months of the year, the S&P 500’s total return is up nearly 17%, the Nasdaq 100’s return is up nearly 40%, the Euro Stoxx 50 index is up nearly 16%, and the S&P High-Yield Bond Index’s return is up nearly 40%. more than 5%. Indian stock markets reached all-time highs last week. Markets are clamoring for both the ‘high’ and ‘long’ aspects of the DM central banker’s current strategy. The resulting effect of these market rallies is to ease financial conditions, which is the opposite of the effect that central bankers seek to create.
In the end, of course, only one side wins. If financial markets are to win, it will be because growth is resilient despite low inflation. If the Fed’s approach wins, markets will have to slide down to reflect the reality of what Powell spoke of as a ‘long high’. Current valuations in most markets, especially for growth stocks, are unsustainable if discount rates on that growth need to remain high over a long period of time.
The domestic situation is slightly different for emerging markets, including India. Pandemic-time flows from liquidity and fiscal taps were much more measured than in DM, and labor-market behavioral effects were much less pronounced. As global supply chains return to normal, commodity inflation remains more or less under control and domestic inflation expectations from the services sector have moderated.
One mechanism by which DM monetary policy can affect India is related to inflows of foreign direct investment, portfolio investment and overseas remittances, the volume of which is affected by competition from upward DM money-market rates. Even if Indian growth prospects are viewed favorably, if short-dollar rates remain high for a prolonged period in the Fed’s bid to tackle inflation in the US, the extraordinary venture capital and private equity flows of the pandemic years Not likely to return for some time.
PS: “If you don’t change direction, you can get where you’re going,” said Lao Tzu
The writer is chairman, Include Labs. Read Narayan’s Mint column at www.livemint.com/avisiblehand
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UPDATE: July 03, 2023, 11:33 PM IST