Will the Fed stop playing the Pied Piper?

The last two decades have been marked by large upheavals in the global economy. We had the dotcom crisis in the early 2000s, then the global financial crisis in 2008 and then the Covid-19 pandemic.

While the global financial system appears to have weathered these crises well, there has been a large cost to pay as unbridled note printing by the advanced economies to avoid recession resulted in mounting debt and high inflation globally.

The US Federal Reserve has been playing the leader in monetary policy formulation in this period, with other central banks marching lock step behind. This was because it was necessary for all economies to be in sync with the US to maintain the spread between the sovereign bond yields, to ensure stability in the currency market.

But there appears to be a growing realisation that this need not continue as the Fed is stuck in a quagmire of its own making. Many countries are already beginning to cut or raise policy rates based on the demands of their domestic economy.

Fed in a spot

Since the global financial crisis in 2008, the US Fed has injecting copious amount of money in to the economy to support growth. As a result, its balance sheet has grown from $900 billion in August 2008 to $8.96 trillion by April 2022.

The high government debt, which currently stands above 120 per cent of GDP, is clearly unsustainable with the resultant interest outgo crowding out other investments. Fed’s policy normalisation since 2022 did shrink the balance to $7.3 trillion by May 2024, but the central bank is now having second thoughts, and has reduced the quantum of tightening in the April policy.

The liquidity sloshing around in the economy has increased domestic demand, pushing up prices. The pandemic and geopolitical tensions further stoked inflation, taking US CPI to 9 per cent by July 2022. Policy rates were aggressively hiked to 5.5 per cent, the level last seen in 2001, to stabilise prices. Though CPI is down to 3.4 per cent as a result of the rate hikes, it continues above the Fed’s target of 2 per cent. This is largely due to core and services inflation remaining sticky due to strong demand.

The IMF’s latest WEO noted, “The exceptional recent performance of the United States is certainly impressive and a major driver of global growth, but it reflects strong demand factors as well, including a fiscal stance that is out of line with long-term fiscal sustainability. This raises short-term risks to the disinflation process, as well as longer-term fiscal and financial stability risks for the global economy.”

Continuation of high interest rates is going to pose a problem, not only for the US government but also to households and businesses, creating credit risk. But the sticky inflation is preventing rate cuts. Given the Catch-22 situation that the Fed is in, its monetary policy is also appearing quite directionless.

Rate cuts and rate hikes

It is therefore not surprising that many central banks have begun delinking their monetary policies from the Fed.

For instance, central banks of South American countries have been easing rates aggressively with Brazil cutting rates by 275 basis point, Chile by 400 bps and Peru by 175 bps since last year. These countries faced high double-digit inflation in 2022 making them raise rates aggressively to over 10 per cent in the current cycle. Advanced economies such as Switzerland, where inflation has been tamed, are also beginning to lower rates. There are strong indications that the European Union will be beginning its policy rate cut cycle soon, with CPI in the region declining to 2.4 per cent. Sweden too cut rates in 2024 to help its sagging economy.

On the other hand, Japan has let go of negative interest rates after eight years, raising its policy rate to 0 to 0.10 per cent from minus 0.1 per cent in its March policy.

With the wages in the country increasing sharply and inflation at 2.8 per cent mark, the bank is clearly wary of continuing ultra-loose policy for too long. Indonesia had to hike its policy rate by 25 basis points in 2024, to buttress its weakening currency.

Impact on capital flows

This disassociation of monetary policies of global central banks from the US Federal Reserve should nudge RBI to cut rates by mid-2024. Given the weakening private consumption, gradual easing of inflation towards the target, and sluggish private capex, rate cuts need to begin soon to give further impetus to the economy.

The key factor that holds RBI back from moving ahead of the US Fed is the threat of capital outflows from debt securities. But there are several reasons why this threat may not be as significant as it was in earlier years.

One, Indian government bonds held by foreign portfolio investors account is not too significant, accounting for just 1.92 per cent of the total outstanding, in December 2023. Therefore selling by FPIs due to any future rate cut may not move the needle much.

Two, the relative stability in the rupee and the demand for Indian bonds due to inclusion in global bond indices lend strength to the yields.

Three, IMF research on capital flows shows that private capital flows are positively correlated with countries’ productivity growth (Aguiar and Amador 2011; Alfaro, Kalemli-Özcan, and Volosovych 2014; Aguiar 2023).

The implication is that while there could be short-term outflows if India begins cutting rates early, higher economic growth and favourable outlook for the country will bring back the investment flows into the country. It’s probably time for the RBI to take a leaf from the Swiss National Bank, Riksbank and others and start moving rates lower.