The world economy
Larry Summers has a piece on the 25 March titled As America falters, policymakers must look ahead in the Financial Times [link + excellent discussion] where he says:
Three months ago I was able to write in this space that in economics the main thing we have to fear is the lack of fear itself. This is no longer true today. With clear evidence of a crisis in the subprime US housing sector, risks of its spread to other credit markets, sharp increases in market volatility, reminders of the fragility of global carry trades and signs of slowing economic growth, there is enough apprehension to go around.
While it would be premature to predict a US recession, there are now strong grounds for predicting that the US economy will slow down very significantly in 2007. Whether in retrospect 2007 will prove to have been a pause that refreshed a nearly decade-long expansion like the growth slowdowns in 1986 and 1995 or whether it will see the end of the expansion is not yet clear.
It is clear though that the global economy has been relying on the US as an importer of last resort; that the US economy has been relying on the consumer for its primary impetus; and that until now consumers have been encouraged to spend their incomes fully or more than fully by being able to access the wealth in their homes.
This growth syllogism has appeared fragile for some time, but has continued longer than many observers expected as US consumers have kept spending even after it was clear that the housing market had peaked and foreigners particularly those in the official sector in Asia and the Middle East have been willing to continue financing, on very attractive terms, the US in importing nearly 70 per cent more than it exports.
But the growth syllogism is now in doubt. Recent developments in the subprime sector exacerbate housings brake on US economic growth. Foreclosures will bloat the supply overhang of houses. At the same time reductions in capital in the housing finance sector and more rigorous credit standards will reduce the demand for new homes. Even as these developments reduce housing prices and the construction of new houses, housing finance problems are likely to magnify wealth effects on consumption as consumers face upward resets on their mortgage rates and are unable to refinance as they had planned, and as home equity, car and credit card lending conditions tighten.
If consumer spending declines and interest rates fall or appear likely to fall, there is the real possibility that the foreign lending to the US that has financed imports far in excess of exports will start to dry up, leading to a combination of higher long-term interest rates and a weaker dollar. This would tend to raise inflationary pressures, transmit US weakness to the rest of the world and could, by discouraging foreign demand for US assets, lead to further downward pressure on investment in plant, equipment and commercial real estate.
How should economic policy respond to a potential fall-off in US demand? The great irony is that just as the worst investment decisions are made by those who do today what they wish they had done yesterday buying assets that have already risen and selling those that have just lost their value so also the worst economic policy decisions are made by policymakers who, instead of responding to current circumstances, seek to rectify past mistakes.
It would have been desirable if policymakers had done more to restrain imprudent subprime lending to households with dubious credit in recent years. But with the sector littered with bankruptcies, this is not todays problem. The problem is the opposite: to avoid a vicious cycle of foreclosures, declining property values, reduced consumption demand, rising unemployment, more delinquencies and more foreclosures.
Some argue that the Federal Reserve should have started tightening monetary policy earlier in the current cycle and avoided what they see as liquidity-driven bubbles. Regardless of the merits of this position, the theory that this constitutes a reason to avoid easing monetary policy, come what may, hardly follows. If, as may prove the case, the dominant economic concern becomes a shortage of demand, it is incumbent on the Fed to provide stimulus so as to maintain conditions for growth and financial stability.
Those in the rest of the world who have been insisting on the global imperative of increased US saving and a reduced US current account deficit should fear getting what they want too quickly. So also should those US observers who have insisted that foreign countries stop artificially holding their currencies down by purchasing dollar assets. While US current account adjustment is a medium-term imperative, an effort to bring it about rapidly in the face of an already declining economy could turn a soft landing into a hard one.
Similar principles can be extended to almost every macroeconomic policy area from fiscal policy to financial regulation. Good economic policies operate counter-cyclically, slowing booms and mitigating downturns. It follows that when the dominant risk changes from complacency and overheating to risk aversion and economic slowdown, the orientation of policy must change as well.
Economic policymakers who seek to correct past errors by doing today what they wished they had done yesterday actually compound their errors. They are in their way as dangerous as generals fighting the last war. We do not yet know how much economic conditions will change or whether current concerns will prove transitory. But if recent developments mark a genuine change, let us hope that policymakers look forwards rather than backwards.
To respond to the first paragraph, I think that while implied volatility of the S&P 500 has reared up from roughly 10% to roughly 14% in recent weeks, it remains at historically low levels when compared with the longer experience, and when compared against the daunting challenges faced by the world economy today.
I think what he's saying to Bernanke & co is "be open minded about a rate cut". This is not the mainstream view. The situation on US inflation is not pretty, with expected inflation embedded in the market for inflation indexed bonds running above 2.2%. My view is that the Chinese appreciation has helped accelerate manufacturing inflation worldwide. The UK CPI is under pressure. Reflecting these fears, and reflecting a very high respect for the importance that the Fed attaches to keeping inflation under control, the market does not expect a Fed rate cut anytime soon. Price data on the options on fed funds futures market can be used to back out the probability of a rate cut, and right now the values are roughly 8% by May, 20% by June and 20% by August.
Stephen Roach has an interview on Foreign Policy which has a grim picture of the difficulties of the world economy. He is away from the mainstream in blaming inflation-targeting. He says:
FOREIGN POLICY: Observers have suggested a number of different reasons for last weeks stock market stumble. What do you think was the main cause?
Stephen Roach: The correction in the Chinese stock market was a very important development. There were new doubts that surfaced with respect to the outlook for the U.S. economy. Those were the two dominant factors. There were other causes: the yen carry trade, or investors simply being caught complacent on a number of risky assets. Those were all facets. But the fundamental story from my point of view was a real one. This was not a trading accident, and it was made in China and America.
FP: What lessons should policymakers take away from what happened?
SR: [Prior to last week], we had seen a dangerous build-up of complacency around the world by investors, by policymakers, and by politicians. And markets were pretty much ripping on their own. The trading action that I thought was most disconcerting was in what has traditionally been the riskiest of assets: high-yield corporate credit in the United States or in Europe, emerging-market debt, and emerging-market equities, where spreads in debt markets had gotten down to levels wed last seen in the late 1990s.
Policymakers, by targeting inflation in the narrow sense, whether its the consumer price index (CPI) or some type of consumption deflator, were ignoring an important responsibility in managing risk and financial market stability. Its very important for central banks, in particular, to have a broad perspective on their mandate, and not ignore the excesses that can build from time to time in asset markets.
FP: Your viewpoint is pretty bearish relative to those of other observers and commentators. What is it, either from your experience or your insights, that leads you to a more pessimistic conclusion than others?
SR: Well, Ive been examined by leading physicians and geneticists, and so far they havent determined anything terribly abnormal in my physical makeup. But I am very suspicious of the view that market fundamentals are sound. The standard response [to last weeks drop] is to say that this was just a market event, its a blip, the fundamentals are sound, and nothing has impacted the underlying strength of the global economy. In many respects, those statements are made by political figures or policymakers who have strong political leanings, or by sell-side analysts who want markets to just rebound and resume their sharp upward assent.
In China, I do see some legitimate reasons for a marked slowdown. In the United States, this post-housing bubble shakeout is going to end up being a lot more serious than most people think. When we woke up last Tuesday, not only did we get news of a huge drop in the Chinese stock market, but earlier in the day in the United States we also got a hugely disappointing report on capital goods orders. It was the fourth disappointment in the last five months. This was one of the sectors that was supposed to be resilient and underscore the case that the U.S. economy had this amazing knack for walling off problems. As the capital expenditures outlook darkens, that [belief] will be drawn into serious question. The one sector thats hanging in there is the consumer, and my guess is thatll be the next shoe to drop. But right now thats a guess, and so far it looks like Im wrong.
Linkages between the world economy and India
Turning to India, see Growth story in volatile times by Ila Patnaik on 9th March for an exposition of how these developments in the world economy matter for us. There was a significant slowdown of exports from all over Asia starting from the middle of 2006. The poor merchandise exports growth seen in India in January 2007 (5.37%) was perhaps, to some extent, driven by this wider phenomenon.
Macro policy and outcomes in India
Much more interesting is her piece A fresh mandate for RBI (20th March) which, I think, makes an important and new point. In a nutshell, the argument is this. Inflation in India is a serious problem, in the worldview of both economists and politicians. In the short run, you can't do anything about the aggregate supply function, so what has to be pulled back is aggregate demand. Aggregate demand is the sum of domestic demand and foreign demand. Raising interest rates hits domestic demand, while an INR appreciation hits foreign demand.
What RBI was doing until a short while ago was remarkable: they were preventing an INR appreciation (which would, normally, have reined in foreign demand by itself). As a consequence, there was ample liquidity in the domestic economy. This led RBI to do things like rate hikes and CRR hikes in combating inflation. These inflicted some pain, though not enough to rein in inflation (we still have a policy rate of roughly 0 in real terms).
What we were left with was a strange combination of a monetary policy which was willing to allow local inflation, and inflict pain on local households and firms, but treated the INR-USD pegged exchange rate as the non-negotiable core. I felt that this strategy is not in India's interests and waited for the politics to work itself out.
Did RBI budge?
It may be the case that some of this criticism of the INR/USD peg is getting through, because we are seeing some give on the part of the RBI:
One problem with the Indian currency regime is that there is no transparency. One never knows what RBI is doing and why. But looking at the INR/USD exchange time-series it looks like RBI did budge. Given the lack of a transparently understood monetary policy regime, one does not know what could come next. Will they now defend Rs.43 per dollar? Or will further appreciation take place?
The dates on this graph are interesting. On 14th March they were at Rs.44.25 and today they're near Rs.43. (My graph is drawn from the US Fed data, and stops at Rs.43.2 on 26 March).
There are long lags in the data, but it my sense is that there has been a slowdown in world output and particularly exports from August 2006 onwards. We have got a one rupee INR appreciation, and my view is that more ought to be in the pipeline. Put together, selling with an appreciating currency into a slowing world economy should give a significant slowdown in exports, and thus help to rein in inflation.
The red line is the CNY and the blue line is the INR; the graph covers two years since the relationship between the exchange rate and trade runs over roughly two years. This CNY dimension cuts in two ways: it helps Indian exports but helps sustain Indian inflation.
The next few weeks are full of imponderables. How badly will the world economy slow down? How will inflation in India react? To what extent will the politics override the RBI operating manual, thus giving an INR appreciation, and a higher short rate? What is the lag structure with which an INR appreciation and higher short rates feed back into inflation? My sense is that the bulk of these uncertainties should get resolved over May and June.