Central banks, via monetary policy, ultimately aim to influence domestic financial conditions which in turn affect economic variables like growth and inflation. Interest rates are only one component of aggregate financial conditions, but probably one that central banks influence the most directly. The other major components of this include relative currency strength, credit spreads, and equity markets. In a phase of same direction policy moves this ability to maintain or ease relative financial conditions via monetary policy action ultimately decides whether such action has been successful or not.
The US Federal Reserve
With the Fed cut yesterday, major developed market central banks have officially begun the process of easing that some of their developing market counterparts have already embarked upon from earlier in the year. Thus the above framework of gauging policy effectiveness via relative changes in domestic financial conditions (of course relative to domestic economic and stability conditions) is a useful way of both monitoring effectiveness of easing as well as in trying to predict the future path of easing for that particular central bank.
Going in, the messaging around the Fed rate cut was going to be tough to execute. This is because the US economy by itself, although slowing, is prima facie merely reverting to its more sustainable trend rate of growth of around (or just under) 2% from the fiscal stimulus fueled above trend of around 3% last year. The consumer is doing well and unemployment rate is very low. Enough jobs are being added thus far to maintain these low levels of unemployment rates. Under such circumstances, it was always going to be tricky for the Fed to confirm to the market’s expectations of multiple rate cuts without a somewhat bleaker assessment of the economy. This kind of an assessment may then have caused damage via the confidence channel. More fundamentally it may have genuinely not be in consonance with the Fed’s honest economic assessment. Under the circumstances it did the best it could, justifying the cut on the basis of the global slowdown (particularly in Euro and Chinese manufacturing), trade related uncertainties, slower than desired US inflation, and a somewhat lower than earlier estimated so-called neutral policy rate. Within US growth dynamics as well, there is a recognition of the slowing manufacturing and business investment part of the economy.
In the press conference post the meet, the Fed chair described the cut as a mid-cycle ‘insurance’ cut in order to make sure that the recovery prolongs in the face of global and trade related headwinds and also to give support to inflation. In particular, he was focused on the cumulative change in financial conditions since early in the year during which the Fed has turned from being on a hiking cycle, to being on a patient hold, to finally cutting rates by 25 bps. Indeed, when looked at this way, and remembering some of the major components of aggregate financial conditions, while over this period the US dollar hasn’t done much, interest rates are substantially lower, credit spread expansion late last year has been arrested and equity markets have largely held. Thus it could be argued that financial conditions have net loosened in the US over the past few months, thus helping to sustain the recovery; a point that the Fed chair mentioned more than once.
The problem of course is with respect to forward guidance. After a long time, there is next to none, barring an impression given that the market shouldn’t expect a series of cuts. If the somewhat underwhelming Fed meet yesterday leads to incremental significant tightening of financial conditions relative to strength of incoming US data and given the prospective actions of other central banks (more on this below), then it is likely that markets will start leading the Fed again. This, if it happens, will be evidenced in a resumption of curve flattening.
The European Central Bank
As against the Fed, the ECB is facing a more dire economic situation and, it may be argued, potentially a weaker tool kit to address it by. Thus both growth and inflation have turned for the worse and there are important potential negative events on the horizon, including the effects from a potentially ‘hard’ Brexit. Thus the need for action is clear and some of it has already started in terms of guidance and proposed resumption of long term refinancing operations. However, the main deposit rate for ECB is already negative and there are some constraints to further meaningful expansion of quantitative easing (some of which may be surmountable via court rulings). There is obviously the related question of the incremental utility of further QE expansion. This is because at least one major intended outcome of QE is to bring down long term rates. But in a world where large swathes of long term rates are already near zero or indeed negative, one wonders how far this effect of QE has to run.
Given the above, the big question with respect to ECB is not whether they will ease, but whether such easing will be effective enough to materially ease their relative domestic financial conditions. On the margin a perceived relatively hawkish Fed is somewhat of an unintended ally for the ECB, in so far as it helps weaken the Euro and eases relative financial conditions in the Eurozone. However, too much of this relative easing may restart concerns at the Fed towards relative tightening of their financial conditions, thereby impacting future US monetary policy decisions!
While we have dwelled on only the 2 major central banks above, other significant geographies are also experiencing their own shares of growth pangs and associated easing expectations. China is notable where some of the new incoming data is weakening again, particularly with respect to industrial profits. Further, stresses in the financial system are also increasingly more evident.
The Case of India
The narrative we are most used to in India in episodes of a global slowdown is that the domestic economy is robust and our external linkages are relatively fewer. Unfortunately, this doesn’t appear to be true in the current case. Thus while the manufacturing slowdown here is consistent with the global manufacturing slowdown underway, we have another issue which is more local; that of the slowing consumer. The best sequence that explains this slowdown is this: income growth in India has anyway been weak for the past few years. However, consumption has been sustained via rising consumer leverage. This is consistent with both the aggressive growth in consumer facing lending books over the past few years as well as the noticeable dip in total household savings over the period. With the housing and non-bank finance lending squeeze underway for the past almost a year now, the leverage effect for the consumer may be slowing. There may be a behavioral aspect here as well where with savings already dipping and the incremental environment turning weaker, the consumer is deciding to cut back. As others have noted before, since this slowdown is backed by a substantial fall off in savings, it becomes that much more difficult to reverse in short order.
In such an environment, there is obviously a role for countercyclical discretionary policy. Fiscal policy is facing exceptional constraints owing to a significant fall off in expected revenues from GST and personal income taxes. Given this, the finance minister has been prudent in not administering any incremental stimulus. Not just that, she has actually hiked indirect taxes to fill some of the gap. It is to be remembered that the discussion here is of flow and not stock. Thus the annual combined deficit when center (on and off balance sheet) and states are added is a hefty 8 – 9% of GDP. However, growth has slowed despite this. Put another way, this deficit isn’t in response to a growth slowdown. That growth has slowed irrespective probably tells to the complete lack of drivers in the private sector over the past few years. The point to note is that there has been no incremental fiscal expansion undertaken in response to the last leg of deterioration in growth.
Given this the role of the other discretionary policy pillar, monetary policy, consequently becomes stronger. As noted before, the RBI / MPC is already easing via all the 3 tools at its disposal: guidance, liquidity, and rates. Indeed, this is for the first in recent memory that all 3 are being used in synchronicity. In particular, the role of liquidity is often under-appreciated, especially in context of bringing down term spreads at the front end of the curve.
With the current local and global backdrop, and with obvious constraints on fiscal policy, it is reasonable to expect the current easing cycle to prolong. At this juncture we are comfortable expecting another 75 bps of rate cuts in this cycle, alongside provisioning of adequate positive liquidity. Risks to the view are from a global turnaround and / or local fiscal policy giving into temptation.
Disclaimer:
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the security may or may not continue to form part of the scheme’s portfolio in future. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. The decision of the Investment Manager may not always be profitable; as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. Neither IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.