Oct. 10--The power of central banks to surprise the markets should never be underestimated. In September, both the Indian and the US central banks managed to surprise the markets in different ways. While the US Federal Reserve decided to refrain from reducing the quantum of its $85 billion a month asset purchase exercise, the Reserve Bank of India (RBI) surprised the markets by raising the repo rate. Both the central banks explained their positions, something that the markets with its collective intelligence failed to anticipate, and have intensely complicated the future policy path.
The Federal Reserve seemed noticeably worried about the tightening of financial conditions, which can affect the pace of improvement in the economy and the labour market. But the problem is that every time the Federal Reserve will move closer to cutting its $85 billion a month asset purchase programme, conditions in the financial markets will tighten. However, the decision to postpone the tapering has not resulted in easing of bond yields to a great extent. This is probably because markets have adjusted to the fact that it is just a matter of time before the US central bank actually starts reducing the pace of asset purchase.
Meanwhile, the effectiveness of continuing with quantitative easing (QE) is increasingly being questioned. Robert J. Shiller of Yale University, who is credited to have rightly predicted two previous financial bubbles, is once again warning about troubling signs in the US housing market ("Housing market is heating up, if not yet bubbling", The New York Times, 28 September). Interestingly, John Authers of the Financial Times in a recent article ("Side-effects that should call time on the QE medicine", Financial Times, 22 September) highlighted that default rate in the US has slipped significantly, which means that the capital is not being used efficiently and troubled companies are able to survive because of lower interest rates. The growing inequality is another source of worry for the US. "Most of the growth is going to an extraordinarily small share of the population -- 95% of the gains from the recovery have gone to the richest 1% of people, whose share of overall income is once again close to its highest level in a century," The Economist reported in its 21 September edition. Stephen S. Roach, former chairman of Morgan Stanley, Asia, and now with Yale University, in an article ("Occupy QE", Project Syndicate, 25 September) also highlighted that the wealthiest 10% in the US benefited the most from the liquidity injection by the Federal Reserve. Furthermore, there have been spillover effects outside the US as well. The current account position has deteriorated for countries such as India, South Africa, Brazil and Indonesia and has complicated matters.
In India, though RBI has raised the repo rate and is increasingly been seen to be moving away from the Wholesale Price Index towards the Consumer Price Index as the key operating variable, this transition may not be easy as the interest rates will have to be increased by a fair amount in order to undertake this policy shift. However, raising interest at this point will affect sentiments and expectations around growth. Notably, RBI will also have to reassess its position on the exchange rate and capital flows, as focus in last few months has been on external sector management.
Interestingly, in a recent paper, Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence (August 2013), which was presented at the annual symposium of central bankers in Jackson Hole, Helene Rey of London Business School argued that cycles in the global financial system transform the trilemma into a dilemma. "Fluctuating exchange rates cannot insulate economies from the global financial cycle, when capital is mobile. The 'trilemma' morphs into a 'dilemma' -- independent monetary policies are possible if and only if the capital account is managed, directly or indirectly, regardless of the exchange rate regime," the paper noted. The paper further argued that there are global financial cycles of capital flows, credit growth and asset prices. Therefore, it is important for financial stability that the capital flows are closely monitored.
The monetary easing in the developed world, particularly in the US actually resulted in higher capital flows in countries such as India. Easy credit conditions in the global markets also resulted in large amount of debt inflow into the country which helped finance large current account deficit. But as soon as the signs of withdrawal emerged, external sector came under serious pressure, reflected in the value of the rupee. Therefore, the management of the external account, perhaps, needs another look. Is a more liberal capital account in the interest of the country or is it likely to increase the level of difficulty in the macroeconomic management? Did easy flow of capital help finance the current account, or did it actually create a wider current account deficit, as is being argued by some ("Ballooning current account deficit: what options?", Economic & Political Weekly, 24 August).
End Note: Policy options are increasingly getting complicated for both the Federal Reserve and RBI. The Federal Reserve, despite the utility of QE being increasingly questioned, is worried about the tightening financial conditions which is likely to happen every time it talks about tapering. The case of RBI is even more curious. On the one hand, it wants to hint that it is not comfortable with inflation, but on the other hand, it starts getting worried when markets react to its signal and yields begin to rise. It will help markets a great deal if central banks define their objectives and choice tools more explicitly in the given time frame.