End of an era of cheap money?

Across the world, there is a sense of apprehension about the economic future owing to signs of inflation and a readjustment of monetary policy in advanced countries that would see a rise in interest rates. For emerging markets like India, this could mean the end of an era of cheap money and the exit of foreign investors from equity and bond markets.

Jay Powell, chairman of the Federal Reserve, said that the Fed was unlikely to begin raising interest rates while it was still purchasing bonds.

THE near-relentless bull run on India’s stock markets seems to be faltering, with signs of a descent from recent peaks. These signs of investor reticence are visible across emerging markets, with India being one of the better performers.

While short-term international and domestic developments are blamed for this reticence, there is a more serious fear keeping policymakers and central bankers awake in these emerging market economies. That is the prospect of an exit of foreign investors from their equity and bond markets, consequent to a readjustment of monetary policy in the advanced economies.

Across the world, there is a sense of apprehension about the near- and medium-term economic future. The proximate cause is inflation in the advanced countries. The United States consumer price index rose 6.2 per cent in October, relative to a year ago. The figure for the United Kingdom was 4.2 per cent, the highest in a decade. In Europe, German inflation of 4.6 per cent in October was at a 28-year high and Spanish inflation of 5.5 per cent is the highest in 37 years.

When prices first started moving upwards, central bankers either dismissed or ignored the tendency. The dominant view was that the price rise was “transitory”, influenced by pandemic-related supply bottlenecks and buoyant energy prices. The assessment was that neither would last, and central banks continued with their focus on feeding the recovery with large volumes of cheap money—a policy that should be abjured if there is any danger of inflation.

Fed’s ‘taper’

There are indications of a change of mind, led by the Federal Reserve. After promising not to retreat until well into next year from its “unconventional monetary policies”—injecting liquidity by buying bonds and keeping interest rates near zero—adopted since the 2008 financial crisis, the Fed has shifted gears. Starting November 2021, the Fed plans to reduce its monthly purchases of $120 billion worth of Treasuries and mortgage-backed securities by $15 billion every month. That would bring “quantitative easing” or large-scale liquidity injection to an end latest by the middle of next year.

However, Richard Clarida, the Vice Chair of the Fed, went public saying that the December meeting of the Federal Open Market Committee would have another look at the pace of the planned “taper” to assess whether changed economic circumstances warranted acceleration.

Sending a signal of a possible hastening of the pace, he referred to the “upside risk” of inflation and the prospect of strong growth in the fourth quarter of 2021. This has implications for interest rates. Earlier, Jay Powell, who has been nominated by President Joe Biden for a second term as Fed chief, had said that the Fed was unlikely to begin raising interest rates while it was still purchasing bonds. But if those purchases are phased out faster, the hike in rates could come sooner.

Since the inflationary trend seems generalised across the advanced economies, the question arises whether bond-buying will be tapered and the interest rates raised in all of them. The Bank of England has signalled that it is on the verge of raising rates, though it held back doing so at its November meeting.

But Christine Lagarde, who presides over the European Central Bank (ECB), seems to be holding out. She said, following what she described as “soul-searching” over the ECB’s view that inflation would subside, the ECB did think that that position still held and it was unlikely to raise rates before the end of 2022, and would continue its bond-buying programme even if at a “moderately lower” pace than the €80 billion-a-month it currently clocks.

There is no unanimity though. Jens Weidmann, whose tenure as President of the Bundesbank and member of the ECB’s governing council is coming to an end, believes that given the inflation outlook, “monetary policy should not commit to its current very expansionary stance for too long”. Moreover, the ECB President’s adamance is beginning to hurt, with the Euro sliding vis-a-vis the dollar.

Capital movement influenced by expectations of a widening of interest and inflation rate differentials is driving that relative decline. The currency’s value touched $1.13 in mid November, which was the lowest since July 2019. That could encourage investors to move to assets denominated in the stronger dollar, aggravating the problem. So the ECB may have to relent.

Soon, a retreat from the era of “unconventional monetary policies”, involving a taper in bond-buying and a hike in interest rates, may be the position adopted by central banks in all developed countries. If that happens, and for long, the turn would mark the end of an era when global financial markets were awash with cheap money. From the point of view of emerging markets like India, that is a serious problem. A chunk of that cheap money flowed into equity and bond markets in developing countries. If such money dries up and rates rise, foreign investors may choose to move out of these emerging markets.

That is what happened in 2013, when the then Fed Chairman Ben Bernanke announced that at some future date the U.S. central bank could begin a taper of its bond-buying programme. The result was turmoil in developing-country financial markets, including India’s, as foreign investors chose to exit.

Bernanke’s threat was not implemented, and action by central banks managed to stabilise markets, and the world returned to business as usual as growth and inflation remained weak, and even collapsed, when the COVID pandemic struck.

Impact on emerging markets

The fear is that all that could change. As of now there are signs of a lull. Bloomberg’s Emerging Markets Capital Flow Proxy Index tracks the combined movement of commodity, equity, bond and foreign exchange market indices, which together appear to mimic the flow of money into and out of emerging markets. Having risen from a low of close to 102 when the pandemic’s effects were felt in March 2020 to a high of 170 in early May 2021, the index has since fallen to around 157.

Although India’s equity markets received $7.1 billion over the first 10 months of 2021, October saw an outflow of $1.8 billion. So India, too, may be feeling the heat, though its substantial reserves give it some room for manoeuvre.

But weaker economies with balance of payments difficulties and limited foreign exchange reserves have much cause to worry. Reza Baqir, Pakistan’s central bank governor, has in an interview to Financial Times warned that developing countries are vulnerable to a shock like the “taper tantrum”. He reportedly said: “If there’s volatility in financial markets because there is a somewhat sudden realignment of expectations of interest rate changes in advanced economies, that volatility will impact emerging markets with high debt and moderate or low levels of reserves more than otherwise.”

But the problem need not be restricted to emerging markets and poor countries. Financial markets worldwide have been riding on large volumes of cheap money, addicted to seeing indices rise most of the time. If a taper and higher interest rates trigger an investor retreat that sets off a more sustained decline, panic could ensue.

Given the intertwined nature of financial i nstitutions, turmoil in bond and equity markets that hurts some financial institutions can soon spread to other segments of the financial structure, and even banks.

In fact, before the onset of the COVID-19 pandemic, the principal reason why central banks in advanced countries stayed with quantitative easing and low interest rates for a decade after the financial crisis was the uncertainty about what the fallout of any unwinding of those unconventional policies would be. But at that time, inflation was low and the recovery moderate, so such policies could be justified. The concern today is whether we are entering a period when that justification does not hold, forcing central bankers to open the doors to a new era the transition to which could be destabilising.

Not surprisingly, there is a strong body of opinion that goes with Christine Lagarde in arguing that the time for retreat has not yet arrived. And there are others who argue that the retreat is not possible. Thus, Ruchir Sharma, who was until recently the chief global strategist of Morgan Stanley Investment Management, has argued in Financial Times that, if despite the return of inflation long-term interest rates have not moved, it is not because of fears that another wave of the pandemic will end recovery or the belief that the inflationary spike is transitory, but because the period of unconventional monetary policies has resulted in a huge spike in debt and put the world in a debt trap.

Given the mountain of debt, bond markets are convinced that any significant rise in interest rates is not sustainable. Inflation, which in Sharma’s view does not appear to be transitory, may force central banks to raise short-term rates, but long-term rates would remain stable even if below the rate of inflation, because even mild tightening will spell trouble. The world, being caught in a debt trap, will remain in a mode where debt only keeps rising. Convenient, but there must be some force that can keep those rates stable and some end to the story.