RBI stimulus. Central banks may taper stimulus soon

Stock markets that have managed to convince themselves that central bank liquidity will continue for a long time will soon have to wake up to taper. For most central banks have begun preparing the ground for an exit. While some central banks such as the Bank of Canada have begun reducing the quantum of bond purchases, others are seriously considering increase in policy rates.

The central bank that everyone closely monitors due to its overarching impact on global liquidity — the Federal Reserve — is however treading extremely cautiously. The Fed Chairman has been stoic and the latest policy meeting statement went all out to assure markets that accommodative policy will be maintained for as long as it takes.

But rumblings were noticed in the minutes of the latest FOMC meeting. A number of participants are reported to have suggested that if the economy continued to make rapid progress towards the committee’s goals, “it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases”. Regulators in other countries are also dropping hints on similar lines.

But it is clear that central banks want the exit from the monetary easing cycle to be smooth, without destabilising financial markets. For the “wealth effect” created by inflated stock prices has a large part to play in driving consumption to fuel economic recovery, once the pandemic curve is flattened.

That said, everyone agrees that expansionary policies cannot be continued for long. Besides taking the government debt to unprecedented levels, continued money-printing is beginning to impact inflation and is creating bubbles in many segments of the market.

Sooner rather than later, central banks will have to begin tapering and stock prices will have to adjust to the new demand-supply equilibrium.

Expanding balance sheets

The scale of stimulus unleashed by central banks last March was like a giant wave that lifted financial markets and helped economies recover faster than earlier anticipated. The stimulus was a combination of massive interest rate cuts and trillions of dollars of money printed to infuse into the economies. The money printing has however resulted in a sharp expansion in the balance sheets of central banks.

The Federal Reserve’s balance sheet expanded 76 per cent in 2020, increasing from $4.1 trillion to $7.3 trillion. The quantum of Coved-stimulus in the US is more than twice the amount infused during the last quarter of 2008, in response to the Global Financial Crisis. Other central banks including the ECB, Bank of Japan and Bank of Canada have also seen their balance sheets expanding sharply after February 2020.

This expansion has resulted in the debt-GDP ratio of these countries rising to alarming levels in 2020. According to the IMF’s fiscal monitor, the US’ general government debt as a per cent of GDP increased from 108 per cent in 2019 to 127 per cent in 2020 and is set to hit 132.8 per cent in 2021. Debt to GDP of UK similarly increased from 85 per cent in 2019 to 103 per cent in 2020 and Canada witnessed a sharper increase from 86 per cent to 118 per cent.

While the debt-GDP ratio of emerging economies such as India, China and Brazil did not exceed 100 per cent in 2020, it has nevertheless registered a sharp expansion due to the extra borrowing to fund pandemic-related expenses.

Fiscal balance of all countries has jumped due to the expenditure incurred during the pandemic and falling revenue. The IMF estimates that average overall deficits as a share of GDP in 2020 reached 11.7 per cent for advanced economies, 9.8 per cent for emerging market economies, and 5.5 per cent for low-income developing countries.

But as economies recover with the progress of vaccination and as government revenues pick-up, fiscal deficit is expected to reduce in 2021, leading to lower need for supporting the economy through additional borrowing.

Inflation raises its head

The other reason why Covid-stimulus may be unwound soon is the impact it has on inflation. As consumption demand began recovering due to containment of the virus in many countries and as governments began spending more on infrastructure and construction to revive their economies, prices of commodities including metals, agri commodities and energy have been shooting higher. Supply constraints due to lower output last year are also contributing to the price increase.

Consumer inflation has become worrisome for many countries including the US, where it hit 4.2 per cent in April. While the Fed has been brushing this aside as a transitory phenomenon, there are many who think that the Fed could be falling behind the curve. Inflation has crossed 5 per cent in many economies including Brazil and Russia.

Inflation is being fuelled by the extra cash in circulation due to stimulus funds as well as the ultra-low interest rates in advanced economies. Pressure is therefore beginning to mount on Fed and other central banks to consider increasing rates.

Asset price inflation

The bigger problem before central bank is the asset price inflation fuelled by low interest rates in the US, Europe and Japan. With over 70 per cent of global funds and investors originating from these regions, lower interest rates here is fuelling carry trade (wherein loans are taken in currencies with lower rates to invest across global asset classes).

Federal Reserve Dallas President Robert Kaplan was quite vocal in a recent interview about asset price inflation, especially in prices of single family homes in the US, which according to him, was caused by continued liquidity infusion by the Fed. He was of the opinion that asset purchases that were initiated during the crisis need to be moderated and the Fed should take its foot off the accelerator gradually.

The RBI Annual report for 2019-20 had an interesting section titled, ‘Is the bubble in stock markets rational?’ The central bank argues that the 100.7 per cent increase in the stock market since the March 2020 lows in the context of 8 per cent contraction in the GDP in 2020-21 poses the risk of a bubble.

The RBI also acknowledges that liquidity injected to support economic recovery can lead to unintended consequences in the form of inflationary asset prices and states that “liquidity support cannot be expected to be unrestrained and indefinite and may require calibrated unwinding once the pandemic waves are flattened and real economy is firmly on recovery path.”

Given the multiple reasons why central banks cannot continue the stimulus forever, it appears to be a matter of time before tapering begins in most economies. Investors of stock markets therefore need to get ready for life without the liquidity support. While some correction in stock prices could be on the cards, if tapering begins, it will be healthy, helping remove some of the speculative froth.