Global economic cues at play

The moves made by central banks globally have a ripple effect across the world

While all central banks have similar mandates in securing growth and price stability, the key central banks such as US Fed and the ECB have also to reckon with the effects of their policies on other economies.

The US Fed’s special position in this regard goes back to the 1940s when the dollar came to be the world’s reserve currency with its value tethered to gold. Though the gold standard is long gone, the dollar continues to be the global currency and works its influences in several ways.

It enables the US to run huge current account deficits without its currency depreciating or interest rates rising, defying conventional economic wisdom, but made possible by the reinvestment of dollars back into US treasuries, stocks and bonds.

Being world currency protects the US economy from the adverse effects of the impossible trinity theorem, since it does not need foreign exchange. This is a mixed blessing for the Fed. The US Fed has three mandated objectives — maximum employment, stable prices, and moderate long-term interest rates.

It considers a long run 2 per cent CPI inflation rate as desirable, suggesting that the Fed fears deflation as much as rising prices. Because long-term employment is determined by non-monetary factors, it has no targets, but its estimate of the long run rate at 4.6 per cent effectively works as a boundary for interest rate policy.

Thus, although current inflation was low at 1.87 per cent, low unemployment rates (4.3 per cent in May) and uptick in growth (2.2 per cent) emboldened it to start raising rates, since it was always keen to move away from near zero.

Its discomfort with low rates is both on account of systemic risks and also to give itself room to lower rates later, if needed. The Fed’s forward guidance is an extremely powerful tool that sets future expectations and influences current spending and investment.

Different strokes for Europe

In the other major zone, the ECB is even more focused on price stability with a similar target of 2 per cent inflation over the medium term, based on the Harmonised Index of Consumer Prices (HICP). But the similarity ends here.

Europe is distinctly different in at least two respects — its economy is more trade dependent than the US and it has a bank-dominated financial system. Currently, the Euro Zone is still recovering from the depressed economic conditions of EMEs (hit by low oil, commodity prices and slump in trade). Their banks were also badly impacted as they had huge credit exposure to the energy sector in EMEs. Therefore, while the ECB believes price stability contributes to both economic growth and job creation, current conditions have translated the mandate into supporting aggregate demand, through a regime of low interest rates and quantitative easing.

In fact, interest rates were kept negative, to encourage banks to lend more instead of keeping reserves. Normally this would have stoked inflation, but its concerns now are low inflation and low growth. Thus far, negative interest rates do not seem to have worked but have adversely impacted bank profits and equity markets. Moreover low rates have upped systemic risks.

But the ECB has shown no signs of change in stance, much to the chagrin of countries such as Germany which, while virtually pulling the Zone, suffers higher inflation impacting real returns for its savers. Internal economy dynamics within the Euro are a major challenge. Moreover, with the US Fed declaring its intent to raise rates over the next year and beyond, the interest differential gap would widen and exert pressure on the ECU.

Back home, the RBI also has monetary stability embedded in its preamble. But rate setting has different dynamics. First, with traditionally high levels of inflation, deflation from low rates is not a threat. Also, with tight regulation (even the so called shadow banking is regulated) the risks of low rates causing asset volatility are insignificant. Finally, interest rate transmission is not very effective, which has to do with several factors, importantly the absence of deep and vibrant debt markets to complement bank lending. Thus, rate setting is always a balancing act between inflation (calling for higher rates) and growth (requiring lower rates), notwithstanding the poor transmission.

The contrast with Europe, which also has a bank dominated financial system, is striking — low interest rates, higher systemic risk and low bank profitability characterise the former, while we have higher interest rates but lower bank profitability. Strong foreign capital inflows (both FDI and portfolio) also pose a challenge to the RBI — it has to choose between not intervening, which leads to rupee strengthening, as it now has, and intervention, which would require sterilisation measures to prevent inflationary pressures building up.

The writer is an independent consultant



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