Is global turbulence likely?

Business Standard, 22 March 2022

The US legislature has approved a remarkably large stimulus package. In the short run, this stimulus package, and the normalisation of the economy owing to large scale vaccination in the US, will generate a demand surge. These developments are likely to generate export buoyancy for India. But there are concerns that this could generate inflation. The US Federal Reserve is committed to a 2% inflation target. When inflationary pressures surface, the US Fed will raise rates. There are slight signs that a rate increase could come in 2023, but there is significant uncertainty. Comparisons with the Indian 2013 currency defence are instructive, and suggest that such a scenario is unlikely.

The US has pulled off a good success on vaccination. About 31% of adults have got atleast one dose, and 17% are fully vaccinated. Their run rate of vaccinations per day is actually improving, going forward. A large pool of vaccinated people in the US are now returning to normal social and economic life. This will create demand for goods and services.

It is estimated that households in the US have accumulated about $1.5 trillion in excess savings through suppressed consumption in the pandemic period. Some of this could generate increased consumption, once households feel that the extremities of health risk and economic risk have subsided. This will create demand.

US legislators have approved a very big stimulus package. Larry Summers has argued that this stimulus is about six times larger than what was done in 2009. He describes it as "macroeconomic stimulus on a scale closer to World War II than normal recession levels". This will create demand. In some other developed countries also, such as the UK, some elements of these phenomena are at work.

These developments are likely to generate buoyancy in purchases by a large number of affluent households in the world economy. This will bolster the fortunes of exporting industries and firms in India. This is a positive for the outlook for India.

But there are concerns about how this will play out. The first element is the radical uncertainty of the situation that we are placed in. There is no good analogue to the world economy of 2020 and 2021, in our historical memory. As a consequence, our conceptual and statistical models are likely to work poorly. Decision making in private and public settings is ultimately based on forecasts and scenarios about the future, and the errors are likely to be larger than usual.

There is concern about a sudden revival of inflation in developed markets. Normalisation of household behaviour, the dry powder of excess household savings, and stimulus could all add up to a surge in household purchases. But a certain proportion of the Covid-induced changes will be permanent. As an example, numerous organisations worldwide will have more work-from-home, and absorb the management techniques of synthesising geographically dispersed talent, as compared with the way things were one year ago. The surge of demand will thus not merely reflect the composition of purchases of one year ago; it is likely to be concentrated upon a certain subset of goods and services.

This is likely to bring back inflation and generate higher rates from the US Fed, which has a 2% inflation target. Reflecting this view, the US 10 year rate has risen from about 0.5% in October 2020 to 1.7% today. This reflects expectations of higher values of the short rate (i.e. the policy rate) over the coming 10 years.

Could this become a little unruly? There is great concern worldwide, about the possibility of an inflation surprise in developed markets, for the period of time in which firms will reallocate productive resources away from areas of sluggish demand to the areas of strong demand.

Some people are worried about a scenario where an abrupt inflation surprise is followed by abrupt actions by the US Fed. In a bad scenario, the US Fed will raise rates in 2022 by a bit. Forecasts embedded in interest rate derivatives markets in the US do not attach a high probability to such a scenario. However, it can be argued that the pessimists about an unruly scenario are buying gold and crypto-currencies, in order to protect themselves; that the surging prices of gold and bitcoin are a new channel which reveals the extent through which these fears are now stalking the global financial system.

The last time the Fed talked about normalisation of monetary policy, there was a `taper tantrum' worldwide, which generated the 2013 currency defence in India, where RBI raised rates by 440 basis points and indulged in many other instruments such as capital controls.

I believe such disruptive events are relatively unlikely. At present, only 7 of the 18 members of the US FOMC predict that a rate increase will come as far out as 2023. In addition, the US Fed is cognisant of the consequences of rapid rate hikes, and is likely to be thoughtful about how monetary policy normalisation is done.

The Fed has learned from the taper tantrum, and will carefully choroegraph words and deeds in the coming years. The 2013 events have also generated learning in India. Monetary policy was placed on a sound foundation through the formal inflation targeting system. There is enough institutional capacity in the Indian MPC that a 440 basis point hike in the de facto policy rate (i.e. the 91 day treasury bill), over a short time period, is unlikely.

For decision makers, the low probability scenario to envision is the combination of a buoyant world economy, a faster than expected increase in the US short rate, and pressure on the rupee to depreciate. Firms who have borrowed abroad, who have significant imports, or buy goods in India that are priced at import parity, might favour a greater extent of hedging their full economic exposure to the exchange rate.

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