The Hindu Business Line : Fallout of interest rate uncertainties

The prospects of a further interest rate rise in the US have serious implications for the world economy. Corporates in India and other developing countries may have to depend only on domestic sources of loan funds. Perhaps, this is all for the good as it will speed up deepening of the bond markets of Asia and Latin America. Dr Reddy always has his guidance right. "Expect the rate to rise, if inflation rises. And as long as OPEC is on top, there is no other way the rate can go, in India or elsewhere".

When the RBI Governor, Dr Y.V. Reddy, was categorical that he intends to act in time if circumstances demand it, he was referring to the need to adjust interest rates upwards if inflation expectations justify such action. This was clearly his "guidance", to use stock market jargon.

The RBI Governor left us in no doubt that his anti-inflation credentials were in good order. There was no obfuscation, no lack of clarity in the Governor's pronouncements. This is commendable, considering what happened recently in that holy of holies, Washington DC.

The Fed Chairman, Mr Ben Bernanke, was forced to clarify his statements on interest rates, an effort that has incidentally left a haze of uncertainty over his intentions.

To begin at the very beginning, Chairman Ben Bernanke let slip an observation in his recent message to the US Congress a sentence that suggested a pause in the string of Fed Reserve's rate hikes. He had said that while there were risks to the inflation outlook, inflationary pressures remain well-contained.

Mr Bernanke also remarked on the possible softening of the US economy in the second half of the year, which would preclude a tightening sequence at that time.

This was interpreted by the markets to mean that the Fed Chairman was hinting at a pause on interest rate tightening, leading to an unintended effect on markets in the US and abroad.

Damage control

Mr Bernanke was quick to rectify the situation. He realized the risks his perceived "dovish" remarks had on the dollar, the commodity market and the stock markets themselves. He clarified to a television anchor that the markets had overreacted to his Congressional testimony. The interchange with the Leebison correspondent made the markets take an about turn.

What concerns us in this piece is not the precise substance of what Mr Bernanke said but the significance of perceptions about central bank communications. This is important because the world seems to depend a great deal on what the Chairman, Fed Reserve, means to convey by his statements.

Mr Bernanke, it must be granted, being a Professor, is much more transparent than was Mr Greenspan. Mr Bernanke has already laid his cards on the table. He is clearly an inflation fighter, whose commitment is — at least on a personal level — to inflation targeting.

He believes that "inflation expectations remain low only so long as the Fed Reserve demonstrates the commitment to price stability".

The recent flip-flop in his recent interactions with the media have, however, served a useful purpose. They have clarified and redefined the direction of US interest rate policy, viz. that it will be in the direction of further tightening — not the reverse.

What is material is that the direction of Fed Reserve policy in the coming months is becoming clearer. Given Mr Bernanke's commitment to fighting inflation, he will surely tighten the rate notwithstanding the prospect of a softer US economic scenario. However, the emerging US political scenario may make a difference.

Political pressures

With the prospects of elections on the horizon, no Fed Chairman can be insensitive to the implications of a tightening of the interest rate.

The observers of Fed Reserve actions in the 1980s recorded how Paul Volcker's tightening led to massive protests all over the country, with business lobbyists sending in bickering petitions and protests to the Congress.

Further, even the hardiest inflation fighter in the Fed is not insensitive to political pressures. So, much of the Fed loosening naturally happens in the period immediately preceding a Presidential election. Will Mr Bernanke be an exception?

The auguries in the US economy are, however, not all bright. The fate of the dollar hangs on the initiatives taken both by the Fed and the US Government. The depreciating greenback — notwithstanding current aberrations to the contrary — may demand raising of the interest rates. On the other hand, if the economy slows down, the Fed may have to lower rates.

Thus, the Chairman of the Federal Reserve faces a difficult task. His actions have an impact not only in US but also on the rest of the world.

If US interest rates rise, the rest of the world will tend to follow if at least to keep capital flows from being sucked in by the US.

Global implications

The prospects of further interest rate rise in the US have thus serious implications for the world economy. For instance, so long, in India, our corporates have tended to resort to external commercial borrowing on the ground that even after allowing for exchange rate premia, the costs of external borrowing are lower. With further tightening of the US rates, this condition may change. Corporates in India and other developing countries may have to depend on their own domestic sources of loan funds. Perhaps, this is all for the good as it will speed up deepening of the bond markets of Asia and Latin America.

One final reflection on Mr Bernanke's to-ing and fro-ing on interest rates. The Wall Street Journal has an interesting comment on this episode. It suggests that Chairman Bernanke may wish he had a single sentence printed on his business card when he responded to CNBC anchor Maria Bartiromo, who asked him the provocative question.

The suggested sentence is "I know you believe you understand what you think I said, but I am not sure you realize that what you heard is not what I meant". A delightful spoof on central bankers' "risks" in public speaking! A statement that is almost Greenspanish in obfuscation, but is definitely not attributed to Greenspan! Surely, Mr Bernanke will have to learn the art of saying what he thinks he means in words that will not roil the markets.

Means what he says

What is certain amidst all this uncertainty following Mr Bernanke's exchanges is that the interest rates are going to rise and we poor mortals have to adjust to this situation as best as we can.

In this connection, it is significant that Dr Reddy had recently participated in a conference on central bank communications held in Mumbai. Hopefully, he has honed his skills at communications far better than Mr Ben Bernanke has shown.

Above all, one thing is certain. Dr Reddy always means what he says, and says what he means. He has his guidance right. "Expect the rate to rise, if inflation rises. And as long as OPEC is on top, there is no other way the rate can go, in India or elsewhere".

What are the implications of such interest rate movements for the economy in general? To be sure, the foremost implication of such rise in interest rates is that investment will react adversely. Corporates will be inclined to redraw their investment plans. So too, the Government's fiscal situation will be affected if interest rates go up.

Savers in India may, however, get better incentives to save. One has to bear in mind, however, that better incentives in one direction reflect costs in another.

The Governor is far too sophisticated an economic administrator to ignore all these diverse implications of higher rates. He will surely do a smart balancing act, although that may end up somewhat on the tightening side rather than the easier money.

"Fasten your seat belts" is the message that Mr Bernanke's flip-flops send to all of us, including the old lady of Mint Street.

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