Central banks, via monetary policy, ultimately aim to influence domestic financial conditions, which in turn affect economic variables such as growth and inflation. Interest rates are only one component of the aggregate financial conditions, but probably one that central banks influence the most directly. The other major components include relative currency strength, credit spreads and equity markets.
US Federal Reserve
With the recent rate cut by the US Federal Reserve, central banks of major developed markets have officially begun the process of easing, joining some of their developing market counterparts which had already started the process earlier in the year. Thus, the above framework of gauging policy effectiveness via relative changes in domestic financial conditions is a useful way of both monitoring effectiveness of easing as well as in trying to predict the future path of easing for that particular central bank.
Going in, the messaging around the Fed rate cut was going to be tough to execute. This is because the US economy by itself, although slowing, is
The Fed chair described it as a mid-cycle “insurance” cut. In particular, he was focussed on the cumulative change in financial conditions since early in the year, during which the Fed has turned from being on a hiking cycle, to being on a patient hold, to finally cutting rates by 25 bps. However, if the somewhat underwhelming Fed meet leads to incremental and significant tightening of financial conditions relative to the strength of the incoming US data, it is likely that markets will start leading the Fed again. This, if it happens, will be evidenced in a resumption of curve flattening.
European Central Bank
As against the Fed, the ECB is facing a more dire economic situation, and — it may be argued — potentially a weaker tool kit to address it by. Thus, both growth and inflation have turned for the worse, and there are important potential negative events on the horizon, including the effects from a potentially ‘hard’ Brexit.
The main deposit rate for ECB is already negative, and one has to debate the incremental utility of further QE (quantitative easing) expansion, in a world where large swathes of long-term rates are already near-zero or indeed negative. Thus, the big question with respect to the ECB is not whether it will ease, but whether such easing will materially ease the relative domestic financial conditions.
India’s relative policy space
While the manufacturing slowdown in India is consistent with the current global manufacturing slowdown, we have another issue which is more local — the slowing consumer. The best sequence that explains the slowdown is this: income growth has anyway been weak for the past few years. However, consumption has been sustained via rising consumer leverage. With housing and non-bank finance lending under a squeeze for almost a year now, the leverage effect for the consumer may be slowing.
In such an environment, there is obviously a role for countercyclical discretionary policy. Fiscal policy is facing exceptional constraints owing to a significant fall off in expected revenues from GST and personal income taxes.
Given this, the role of the other discretionary policy pillar, monetary policy, consequently becomes stronger. The RBI/MPC (Monetary Policy Committee) is already easing via all the three tools at its disposal — guidance, liquidity and rates.
With the current local and global backdrop, it is reasonable to expect the current easing cycle to prolong. At this, juncture we are comfortable expecting another 75 bps of rate cuts in this cycle, alongside provisioning of adequate positive liquidity. Risks to the view are from a global turnaround and/or local fiscal policy giving into temptation.
The writer is Head – Fixed Income, IDFC AMC