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Fed and the unknowns

The best it can do for its new normal is to preserve the old abnormal: keep rates low

Written by Bhaskar Chakravorti |
Updated: September 10, 2015 12:15:54 am
global economy, banking system, GDP, Stock markets, Raghuram Rajan, China economy, sesex, iecolumnist, Bhaskar Chakravorti, The indian express Raghuram Rajan

The global economic policy elite have been tuning in to goings-on in an outpost along the valley floor of the majestic Teton mountains in the northwestern United States. I speak, of course, of the annual late-August confab of central bankers and economists hosted by the Federal Reserve Bank of Kansas City in Jackson Hole. Picture-perfect Jackson Hole, for one, is far from anybody’s conception of a hole. It is also far from Kansas City. Most importantly, it is far from the dismal everyday realities for the muckety-mucks of the world monetary order, who must make the trip to “step back and challenge their assumptions”, according to a very pleasant history of the confab put out by the organisers. This year, try as they might to step back from it, the recent gyrations of stockmarkets from Shanghai to Wall Street could not have been too far from any attendee’s mind.

This year also happened to be the 10th anniversary of a University of Chicago professor, Raghuram Rajan, taking the message of challenging assumptions a little too seriously and attracting the scorn of the Jackson Hole elite. He had bad-mouthed the most celebrated of financial innovations, the likes of credit-default swaps and mortgage-backed securities, claiming that they were creating conditions for a “full-blown financial crisis” (in his words). It didn’t take more than three years for him to be proven right and for the elite to have egg on their faces.

In response to the crash of 2008, the US Federal Reserve had taken the unprecedented step of dropping its benchmark interest rate to a level close to zero and keeping it there for almost seven years. Now, Fed officials are considering whether it is time to raise the rate to more “normal” levels; this, in fact, was the talk of Jackson Hole this year and the reason why there was so much worldwide interest in the gathering. In a recent interview, now RBI Governor Rajan cautioned: “If you are not careful about the volatility you are creating, the others have to respond and everybody is worse off.” It would be wise for the Jackson Hole elite to listen to the man.

To be clear, interest rate increases by the Fed profoundly affect the emerging markets (EMs) in particular. A rate hike would likely lead to a stronger dollar, causing global investors to park more of their money in the US, instead of in EMs. This, in turn, could affect their currencies, exports and even employment levels. India, too, has reason to be following these issues closely, though it is less fragile than it was even a year ago. Like other EMs, India may have to build up reserves as a cushion against any potential fallout from the Fed’s actions. While cheap oil helps, in topping up its reserves, India will be decreasing its demand for goods from the US and elsewhere.

The Jackson Hole gathering ended without a clear sign of the Fed’s intent on next steps. The debates at the confab do point to some central dilemmas for central bankers. Three major uncertainties will give the Fed reason to take a deep breath before making any decisions.

For one, US policymakers have been taken aback by the persistence of low inflation in the country. Inflation was still running at just 1.2 per cent a year — well below the Fed’s target of 2 per cent. It is useful to recall that the Fed has been tasked by the US Congress to maximise employment and maintain stable prices. Despite the steadiness of the post-2008 recovery, wage growth in the US has so far been modest.

Couple this with the disappointing jobs growth numbers from September 4, and it is not unreasonable to expect that there is still room to push towards the twin goals of maximum employment and price stability. A premature rate hike could run the risk of halting that process.
In addition to the present, the future is shrouded in macroeconomic and geopolitical unknowns. There is continued downward pressure on oil prices. Add to that the sharp slowdown in China’s economy, and we can expect further declines in commodity prices.  This means there will be further risk that the Fed will not make its inflation target. In such scenarios, an argument can be made for a return to further monetary easing, rather than a rate hike.

A third uncertainty source is, of course, China, and, by extension, other EMs. China’s debt, at $28 trillion in 2014, is 282 per cent of its GDP. The Shanghai index dropped dramatically, the government devalued the renminbi and cut interest rates. With falling commodity demand from China, the currencies of the major commodity-suppliers to China — South Africa, Brazil, Indonesia, Russia — have been simultaneously hit. These are also countries with severe institutional voids and poor political stewardship. But with EMs producing close to 40 per cent of the global output, a further slowdown in these economies, triggered by higher interest rates in the US, risks contaminating the entire world economy. With the EU and Japan struggling, the last finger in the global economic dike is that of the US. Pulling that finger out to see which way the wind is blowing could present many perils.

In sum, there are still rational arguments to be made that the best the Fed can do for its new normal after its upcoming September meeting is to preserve the old abnormal — keep the rate low. Of course, it is also reasonable to grumble about the free ride the low-rate regime gives to Wall Street and the fat cats of the banking system.

My advice? It is time for India’s policy elite to get beyond Jackson Hole and placing bets on the next shoe dropping. With oil and commodity prices low, this is a rare window for India to take bolder measures. Stop fretting about economists presenting papers in distant mountain retreats and get back to the ground level: Long-sighted policy reform, investment in the long-term, fixing the track records of poor corporate profitability and bad loans in the state banking system, among others. This is a rare opportunity to build a more solid framework for India’s growth in the real economy. It is time to be the anti-Jackson Hole: step forward and take actions that are resilient, no matter which assumptions — about the Fed or China — turn out to be true in the end.

The writer is senior associate dean of international business and finance at Tufts University’s Fletcher School. He’s also the founding director of the Institute for Business in the Global Context and author of ‘The
Slow Pace of Fast Change’

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