Powell’s surgical strike on interest rates ‘pivot’ expectations

While the direction of Jerome Powell’s much-anticipated speech at the Jackson Hole Symposium was not entirely on unexpected lines, the tone and nature of its delivery was. When the S&P 500 had rallied almost by 20 per cent till a week ago from its June lows, it was reflecting strong hopes of a pivot at some point by the US central bank. However, what Powell actually delivered spooked the US markets on Friday (3.4 per cent fall in S&P 500 ).

The speech, which ran just a little over eight minutes, was crisp, pointed and strong, leaving no scope for ambiguity — bringing down inflation to 2 per cent was the only priority of the central bank, and if that is going to cause pain to the markets and economy — that is the price to pay for the greater good.

Invoking the 1970s

When the most severe economic crisis in nearly a century unravelled in 2008, the then Fed Chairman, Ben Bernanke, invoked lessons learnt from mistakes made during 1930s that caused the the Great Depression. Those lessons were invaluable in avoiding a repeat of the deflationary spiral that accentuated the economic crisis in the 1930s. Low interest rates and quantitative easing were the tools the US Fed embarked on to avoid the deflationary spiral.

This time, when the most severe inflationary threat in nearly half a century is unravelling in the US, Powell in his speech invoked the 1970s — a decade of high inflation and economic stagnation in the US — resulting in what is known as stagflation. Part of what caused the problem in the 1970s was the pivot (reducing interest rates) the US Fed under Arthur Burns did then when early signs of inflation cooling off emerged. The result of that error was the re-emergence of inflation that was even stronger and more entrenched. It finally required a ‘Volcker Shock’ of increasing US policy interest rates in early 80s to the high teens-20 per cent to win the battle over inflation.

Powell, in referring to lessons learnt from 1970s, sent a strong and clear message. He is laser-focussed on not repeating the central bank’s mistakes of the 1970s just as Ben Bernanke did not want to repeat the mistakes of 1930s. That leaves no scope to reduce interest rates as markets were hoping.

What it means for Indian markets

‘India is a domestic demand-driven economy’, ‘Indian flows into markets are strong’ — such arguments often come up as counters when there is risk of global monetary tightening. However, the fact remains that along with the US and many other global markets, Indian markets, too, have rallied whenever hopes of easy money has been in fore. Most recently, Indian markets too had rallied from June lows by around 15 per cent on hopes of Fed pivot by sometime early next year.  

Thus, logically, if possibility of pivot by the Fed was good for Indian markets, then as a consequence ‘no pivot’ must be negative.  A more stubbornly restrictive US Fed will have strong consequences for global economy. Powell on Friday, explicitly stated that a restrictive monetary policy for longwill come with pain for the economy — something he had not forthrightly stated until then. Pain for the US economy will come with a higher than anticipated slowdown for global economy and will have its impact on Indian economy as well. Not to mention the fact that FPI flow into India too could get negatively impacted for a longer time than originally anticipated, as the Fed keeps rate high for longer.

A stronger US dollar for longer is also a prospect to be factored. Cumulatively, the global slowdown will negatively impact corporate earnings over the next year or so, and higher interest rates will also result in PE multiple contraction for stocks.   

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