The question of US monetary policy
Business Standard, 13 December 2021
Monetary policy in the US is an important factor influencing the Indian economy. Headline inflation in the US has reached 6.8%, the highest value in 40 years, and well above the inflation target of 2%. The US Fed faces a difficult choice. Three scenarios can be envisioned with different paths for the US short rate and for US monetary policy surprise.
Macro policy is often hesitant and late, as assessing conditions in the macroeconomy is difficult in real time. Two exceptions to this rule were the crisis of 2008 (when Lehman filed for bankruptcy in September 2008, it was clear that the world economy was in for bad times) and the pandemic (by February 2020 it was clear that the world economy was in for bad times). Macro policy in the US responded strongly in 2020 with World War 2 levels of fiscal deficit and monetary policy easing.
By late 2021, at the late stages of the pandemic, US macro policy is grappling with the problem of high inflation. There is a direct conflict between the deeply wired institutional objective of the US Fed -- 2% year-on-year inflation -- and present conditions of 6.8% inflation. Standing in December 2021, we are now in a time of significant macroeconomic uncertainty; it is not a moment like September 2008 or February 2020 where it was easy to make macro policy decisions. Three scenarios can be sketched.
In the first scenario, the present stance of the US Fed will prove to be correct. Inflation will rapidly subside, partly through US fiscal consolidation. The retreat of the pandemic will generate supply chain healing, and household consumption switching back from buying goods to buying services. Only mild tightening of monetary policy will be required in 2022, and through 2022 the year-on-year inflation will steadily decline. Inflationary expectations will not become unhinged: firms and workers will continue to use 2% expected inflation in determining their behaviour. In this scenario, today's high US inflation is just a problem of restarting the world economy, and once the world economy is back in action, the problem will go away.
In the second scenario, the US Fed moves pre-emptively, tightening monetary policy significantly in 2022 and 2023 to fight off the inflation. Modern economic institutions have a slogan "Say what you will do, and then do what you just said". Monetary policy will surprise, potentially starting from the FOMC meeting of 13/14 December.
In the third scenario, the US Fed is optimistic that it is in the first scenario, but in fact inflation persists and inflationary expectations get unhinged. In this event, they will be caught on the wrong footing, they will play catch up, and the adverse welfare consequences will be greater.
The most important question in global economics is: Which of these three scenarios will play out? It is a time of acute uncertainty and nobody knows what will happen.
In the second and third scenarios, monetary policy surprises from the Fed will make waves in the global financial system. When interest rates in the US go up, capital tends to retreat from illiquid and risky assets outside the US. This will have an adverse impact in the risky and illiquid corners of the global financial system, such as EM real estate.
Within the US, inflation hawks are arguing that the Fed should embark on the second scenario while others are suggesting the first scenario will work out. If the Fed now chooses to be mild, thus ruling out the second scenario, there will be a debate about whether firms and households are anchored around 2% inflation or not, which will determine whether and when the Fed will chase. Unlike what we often see in the Indian macro policy discourse, nobody in the US is suggesting that the inflation target be abrogated; the only debate is about how and when to act in getting there.
At many points in history, US tightening has had important consequences for the world economy. When rates are near 0 in the US, it is efficient to borrow there and invest in high yield assets worldwide. When rates are low in the US, many institutional investors have no choice but to leave the US in the search for higher expected returns. Conversely, high interest rates in the US suck capital into the US. In international asset pricing, the cost of capital goes up, and the NPV of Indian equities will decline. When US monetary policy tightens, many dubious schemes fall apart, as we saw with the financial scandals in India from 2008 to 2013. As Warren Buffet said, Only when the tide goes out do you discover who's been swimming naked.
In addition to this, there is a second dimension. This is about autonomy of monetary policy. Under normal circumstances, the retreat of capital from EMs should generate EM currency depreciation. When an EM central bank is focused on its own domestic inflation target, this works out fine. But when an EM central bank tries to fight the currency depreciation, this can become unpleasant. High interest rate hikes are required to defend the exchange rate, which is often harmful for the local economy. As an example, in the "taper tantrum" of 2013, RBI raised rates by 440 bps to defend the rupee. With the benefit of hindsight, this decision does not look so good.
We in India are better off today, compared with 2013, in that there is a formal inflation target. This increases the possibility that RBI will stay focused on modifying the short rate, from time to time, in a way that gets Indian headline inflation to the target of 4%. But we are still at the early stages of this journey. Inflation targeting in India only began on 20 February 2015. Economic agents are curiously watching RBI, wondering about the extent that it will walk the talk. USD/INR volatility in the current period is at 5.1% annualised, which is not consistent with a flexible exchange rate.
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