Powell said, “My view is that the substantial further progress test has been met for inflation,” and that “There has also been clear progress toward maximum employment.”
The actual weather in the valley and the town of Jackson Hole was more or less in harmony with the features of a retreating summer, opening at low temperatures, and then rising to a more salubrious level. The customary Jackson Hole address of the Fed Chairman too raised enormous amount of interest among the investors, and the world markets too, in the last one week or so. This was because everyone expected the Fed Chairman to come out more clearly on the Fed’s plan for the future. To be more precise on the accommodative monetary policy.
For those who have read the minutes of the FOMC meeting of July, it was amply clear that the Fed was going to taper off the asset purchase programme much earlier-than-expected. There are two important aspects to this. The first is the asset purchase programme itself, of $120 billion per month, and the second, and more substantial part, is the actual timing of the base rate hikes.
However, it is also important for the central bank to keep the cost of long-term borrowing as low as possible so that the prevailing economic conditions do not affect business and industry. The rate cuts and the injection of liquidity through asset purchases helped in bringing these rates to low levels, to 0 percent to 0.80 percent levels. Consequent to this the US economic growth suddenly picked up substantially, and the rate of retail inflation has also moved up. Under such circumstances it may not be in the interest of the economy to continue with a cheap money policy. Therefore, the tapering off is to begin soon. The Treasury Secretary, Janent Yellen, said many times that higher rates would be good for the US economy.
Powell said, “My view is that the substantial further progress test has been met for inflation,” and that “There has also been clear progress toward maximum employment.” The actual numbers have been supporting this statement for the last couple of months now. The US CPI registered a rise in July to the tune of 0.50 percent on a month-on-month basis, the annual inflation rate at 5.40 percent, and the core inflation at 4.30 percent. The headline inflation in July was at the same level in June while the core inflation was a shade higher at 4.50 percent. It looks like inflation is probably stabilising at these levels with some variability here and there over time. It also rules out the probability of inflation moving any higher from here. Inflation is more widespread and deeper now with the trend seen in the prices of a larger number of goods and services. Housing costs, medical care, recreation costs, apparel prices. There is a kind of spreading out of the price pressures into more commodities. The price developments have been quite in line with expectations. The cause of inflation is that demand is outstripping supply, and the pandemic-led supply disruptions, and the truncated ability to revive production, have caused much of this price spiral. While we may not see the inflation rate going up from this level, it may, in all probability, sustain near around these levels for a longer time. That would be a signal for action.
Yet another factor that adds to the evolving situation is the developments on the employment front. On the employment front, the numbers show scarcity of hands. Interestingly the number of small businesses that are facing labour shortages is relatively higher this time around, and the issue is serious as they are not able to find people locally. Even at the national level, the job openings outnumber the actual hiring. This adds to labour costs and results in high product prices and inflation. One component which is of special significance is the housing costs in the US which is also on an upward spiral and it has weightage of 30 percent in the price index. Any rise in housing costs is bound to stay at high levels longer-than-expected as the trend in the past has been so. While this component may not push up prices much, it will prevent the price level from coming down, and hence, inflation may not be transitory.
Tapering is invariably followed by higher rates, and this may have two specific impacts. The asset prices may start coming down, and the US Dollar may start appreciating. This may not be evident from the first response to the statement on tapering. That will gradually emerge after a while as professionals digest the statements and assimilate the intent. The market response yesterday was quite like, we knew it all and that that it was in the coming.
In the last tapering certain trends were witnessed. The emerging market currencies weakened, and the asset prices moved lower. But it may not be entirely the result of tapering that the emerging market asset prices came down. Usually, in times of accommodative policy in the US and Europe the emerging markets witness good inflows which is money chasing riskier assets and higher return. Such moneys may move out as tapering starts. But the more important aspect of this is that the emerging market indexes continuously rally as money flows in, and the markets touch relatively expensive levels, or to put in in better terms, “fair valuation” and from such altitudes it is obvious that some corrections may happen. Therefore, we cannot put the blame for market corrections in emerging markets entirely to tapering. While the Fed Chairman’s statement has covered only tapering at this time it is highly likely that market rates may also start rising, and the base rate too. The observed behaviour of central banks on both sides of the Atlantic is that when it comes to cutting rates, they are slow, but when it comes to hiking rates, they act relatively more swiftly. Therefore, it is only a matter of time before the rates would start rising. In the 2013 tapering the emerging markets gave returns close to – 10 percent, and this cannot be ruled out, as we see higher bond yields and a rising dollar.
Economies which are fundamentally sound, because of the consumer base and the corporate performance, like China, India, or Singapore, could see some volatility, but the strong fundamentals will provide the long-term anchoring for investors to stay around for longer time and reap the dividends. More than the impact of the Fed tapering, the normalization by the local central bank would be more material in this case. The RBI has already initiated the normalization with a hike in CRR to the tune of 1 percent effected in March and May this year, and the Variable Rate Reverse Repos announced in the last policy. But there is no credit offtake as yet. There is an old saying, when you are going to the temple grounds to see the festival, what is the need to describe it in advance.
Published in Moneycontrol.com