Vivek Kaul
The only economic theory that works all the time is that no economic theory works all the time.
Since May 2013, analysts, economists and journalists have fettered over what will happen once the Federal Reserve of the United States, the American central bank, starts to taper.
The Federal Reserve had been printing $85 billion every month to buy bonds. By buying bonds, the Federal Reserve pumped money into the financial system. This was done so as to ensure that there was enough money going around in the financial system leading to low long term interest rates.
Since December 2013, the Federal Reserve has been cutting down on the amount of money that it has been printing to buy bonds. This cut down in the total amount of bonds being bought by the Federal Reserve by printing money, is referred to as tapering.
In a statement released yesterday (i.e. March 19, 2014) the Federal Open Market Committee (FOMC) said that henceforth it would buy bonds worth only $55 billion, every month. At the current pace it is expected that the Federal Reserve will stop printing money to buy bonds by October 2014.
When Ben Bernanke, who was the Chairman of the Federal Reserve till February 3, 2014, had first suggested tapering in May 2013, it spooked financial markets all over the world very badly. Institutional investors had borrowed money at low interest rates prevailing in the United States and invested that money in financial markets all over the world.
This trade referred to as the dollar carry trade wouldn’t be viable any more, if the Federal Reserve started to taper. Tapering would ensure that the amount of money floating around in the financial system would come down and hence, interest rates would start to go up.
And once interest rates started to go up, the dollar carry trade wouldn’t work, that was the fear among institutional investors. This would lead to them selling out of financial markets all over the world and taking their money back to the United States.
In the Indian context it would have meant the foreign institutional investors exiting both the Indian stock and bond market. As they would have converted their rupees into dollars, there would have been pressure on the rupee, and the currency would have depreciated against the dollar.
In fact, between the end of May 2013, when Bernanke suggested tapering for the first time, and August 2013, the rupee fell from 55.5 to a dollar to close to 69 to a dollar. A lot of money was withdrawn from the Indian bond market by foreign institutional investors. Also, between June and August September 2013, the foreign institutional investors sold out stocks worth Rs 19,310.36 crore from the Indian stock market.
But after yesterday’s decision by the FOMC to cut down on bond purchases by $10 billion to $55 billion, the financial markets around the world have barely reacted.
The S&P 500, one of the premier stock market indices in the United States, fell by around 0.61% yesterday. Closer to home, the BSE Sensex, has barely reacted. As I write this it has fallen by around 28 points from yesterday’s closing level and is currently quoting at 21,804.8 points.
So, what has changed between May 2013 and March 2014? Since December 2012, the Federal Reserve had been following the Evans rule (named after Charles Evans, who is the president of the Federal Reserve Bank of Chicago). As per this rule, the Federal Reserve will keep interest rates low till the rate of unemployment fell below 6.5% or the rate of inflation went above 2.5%.
The rate of unemployment in the United States has been falling for a while and currently stands at 6.7%, very close to the 6.5% mandated by the Evans rule. The trouble here is that the unemployment number has not been falling because more people are finding jobs. It has simply been falling because more people have been dropping out of the workforce. The unemployment rate does not take into account people who have dropped out of the workforce. It only takes into account people who are still in the workforce and are not able to find jobs.
In December 2013, nearly 3,47,000 workers left the labour force because they could not find jobs, and hence, were no longer counted as unemployed. This took the number of Americans not working to a record 102 million. As Peter Ferrara puts it on Forbes.com“In fact, all of the decline in the U3 headline unemployment rate since President Obama entered office has been due to workers leaving the work force, and therefore no longer counted as unemployed, rather than to new jobs created…Those 102 million Americans are the human face of an employment-population ratio stuck at a pitiful 58.6%. In fact, more than 100 million Americans were not working in Obama’s workers’ paradise for all of 2013 and 2012.” Interestingly, the labour force participation rate, which is a measure of the proportion of working age population in the labour force, has slipped to 62.8%. This is the lowest since February 1978.
In it’s latest policy statement issued yesterday, the Federal Reserve seems to have junked the Evans rule. As the statement said “In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.” Federal funds rate is the interest rate that banks charge each other to borrow funds overnight, in order to maintain their reserve requirement at the Federal Reserve. This interest rate acts as a benchmark for business and consumer loans.
What this means is that instead of just looking at the rate of unemployment and the rate of inflation, the Federal Reserve will take a look at other factors as well, before deciding to raise the Federal funds rate. What this tells the financial markets all over the world is that the Federal Reserve will continue to ensure low interest rates in the United States, in the time to come, even though it will most likely stop printing money to buy bonds by October 2014.
In fact, in the press conference that followed the FOMC meeting, Janet Yellen, the Chairperson of the Federal Reserve was asked how long did she think would be the gap between the end of bond buying and the Federal Reserve starting to raise interest rates. “It’s hard to define but, you know, probably means something on the order of around six months,” replied Yellen.
This spooked the financial markets briefly because it meant that the Federal Reserve would start raising interest rates by around April next year. But Yellen quickly clarified that any decision to raise interest rates would depend “on what conditions are like”.
So what this means is that the Federal Reserve will ensure that interest rates in the United States continue to stay low. Hence, the dollar carry trade will continue, much to the relief of global institutional investors.
Peter Schiff the Chief Executive of Euro Pacific Capital explained the situation best when he said “The Fed will keep manufacturing excuses as to why rates can’t be raised. Whether it’s a cold winter or a hot summer, a geopolitical crisis, or an unexpected sell-off in stocks or real estate, the Fed will always find a convenient excuse to postpone tightening. That’s because it has built an economy completely dependent on zero percent interest rates. Even the smallest rate shock could be enough to push us into recession. The Fed knows that, and it is hoping to keep the ugly truth hidden.”
To cut a long story short, the easy money party will continue.
The article originally appeared on www.FirstBiz.com on March 20, 2014, with a different headline
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Federal Funds Rate
No, Subbarao won’t be able to clean UPA’s garbage dump
Vivek Kaul
Duvvuri Subbarao, the current governor of the Reserve Bank of India must be a troubled man these days, professionally that is. The gross domestic product (GDP) growth has fallen to 5.3% for the period of January to March 2012. And now he is expected to come to the rescue of the Indian economy by cutting interest rates, so that people and businesses can easily borrow more, and we all can live happily ever after.
Cows would fly, only if it was as simple as that!
The mid quarter review of the monetary policy is scheduled for June 18,2012. On that day the Subbarao led Reserve Bank of India(RBI) is expected to cut the repo rate by at least 50 basis points (one basis point is one hundredth of a percentage). The repo rate is the rate at which banks borrow from the RBI.
Repo rate is a short term interest rate and by cutting this interest rate the RBI tries to manage the other interest rates in the economy, including long term interest rates like the rate at which the bond market lends to the government, the interest offered by banks on their fixed deposits, and the interest charged by banks on long term loans like home loans, and loans to businesses.
But the fact of the matter is it really has no control on these interest rates in the current state of things. To understand why, let us deviate a little.
Greenspan and Clinton
Alan Greenspan and Bill Clinton came from the opposite ends of the political spectrum. Greenspan had been a lifelong Republican whereas Clinton was a Democrat. Unlike India where there are a large number of political parties, America has basically two parties, the Republican Party and the Democratic Party. Greenspan was the Chairman of the Federal Reserve of United States, the American central bank, from 1987 to 2006.
But despite coming from the opposite ends of the political spectrum they got along fabulously well. In fact, when Clinton became the President of America in early 1993, Greenspan approached him with what Americans call a “proposition”.
Greenspan told Clinton that since 1980 the rate of inflation had fallen from a high of around 15% to the current 4%. But during the same period the interest rate on home loans had fallen only by 400 basis points from 13% to 9%. Despite the fact that the Federal Funds Rate (the American equivalent of the Indian repo rate) stood at a low 3%.
Why was the difference between the Federal Funds rate which was a short term interest rate and the home loan interest rate, which was a long term interest rate, so huge?
High fiscal deficit
The difference in interest rates was primarily because of the high fiscal deficit that the government of United States was incurring. Fiscal deficit is the difference between what the government earns and what it spends in a particular year.
When Clinton took over as President on January 20, 1993, the American government had just run a record fiscal deficit amounting to $290.3billion or 4.7% of the GDP for 1992. And this had led to high long term interest rates even though the Federal Reserve had set the short term Federal Funds rate at 3%.
The government was borrowing long term to fund its fiscal deficit. And since its borrowing needs were high because of the large fiscal deficit it needed to offer a higher rate of interest to attract lenders. When the government borrowed more it crowded private borrowing, meaning, there was lesser pool of “savings” for the private borrowers to borrow from.
Hence, banks and other financial institutions which needed to borrow in order to give out home loans had to offer an even higher rate of interest than the government to attract lenders. Even otherwise, the private sector has to offer a higher rate of interest than the government, because lending to the government is deemed to be the safest form of lending. Due to these reasons the difference in short term interest rates and long term interest rates in the US was high. So the repo rate was at 3% and the home loan rate was at 9%.
The proposition
Greenspan was rightly of the opinion that a high fiscal deficit was holding economic growth back. This was the argument he made to President Clinton when he first met him. As Greenspan writes in his autobiography The Age of Turbulence – Adventures in a New World “Long term interest rates were still stubbornly high. They were acting as a brake on economic activity by driving up costs of home mortgages (the American term for home loans) and bond issuance.”
Other than the government which issues bonds to finance its fiscal deficit, companies also issue bonds to raise debt to meet the needs of their business. If interest rates are high companies normally tend to put expansion plans on hold because high interest rates may not make the plan financially viable.
Greenspan’s proposition to Clinton was that if the Wall Street got enough of a hint that the government was serious about bringing down the fiscal deficit, long term interest rates would start to fall . This would be good for the overall economy because at lower interest rates people would borrow more to buy houses and as well as everything else that needs to be bought to make a house a “home”.
As Greenspan writes “Improve investors’ expectations, I told Clinton, and long-term rates could fall, galvanizing the demand for new homes and the appliances, furnishings, and the gamut of consumer items associated with home ownership. Stock values too, would rise, as bonds became less attractive and investors shifted into equities.”
The US Congressional and Budget Office(CBO), a US government agency which provides economic data to the US Congress (the American parliament) to help better decision making, upped its projection of the fiscal deficit at that point of time. It said that the fiscal deficit is likely to reach $360billion a year by 1997. This data point put out by the US CBO helped buttress Greenspan’s point further and Clinton decided to do something about the fiscal deficit.
The Clinton plan
Clinton put out a plan which would cut the deficit by $500billion over a period of four years through a combination of higher tax rates as well as lower spending by the government. The fiscal deficit of the United States of America which had been growing steadily for years, started to fall from 1993. In 1993, it was down by 12% to $255billion. By 1997, the fiscal deficit was down to $21billion. In Clinton’s second term as President, the deficit turned into a surplus, something that had not happened since 1971. Between 1998 and 2001, the US government earned a surplus of $559.4billiondollars.
A lower fiscal deficit led to lower long term interest rates and good economic growth. The United States of America grew at an average rate of 3.9% between 1993 and 2000. In the eight years prior to that the country had grown at an average rate of 2.9% per year. So the US grew at a much faster rate on a higher base because the fiscal deficit was turned into a fiscal surplus.
This was also the period of the dotcom bubble but the fiscal surplus was clearly not the reason for it.
The moral of the story
As we clearly see from the above example, at times there is not much that a central bank can do on the interest rate front, especially when the government is running a high fiscal deficit. As I have often said over the past one month the fiscal deficit of the government of India has increased by 312% between 2007 and 2012. During the same period its income has increased by only 36%. The fiscal deficit target for the current financial year is at Rs Rs 5,13,590 crore, a little lower from the last year’s target. But as we have seen in the past this government has a tendency to miss its fiscal deficit targets regularly. So the government will have to borrow to finance its fiscal deficit and that means an environment in which long term interest rates will remain high.
In fact, some banks have quietly raised the interest rates they charge to their existing home loan borrowers, after the Subbarao led RBI last cut the repo rate by 50 basis points on April 17, 2012.
The interest being charged to some of the existing home loan borrowers has even crossed 14.5%, a difference of more than 6% between a long term interest rate and the repo rate, as was the case in America.
India has another problem which America did not in the early 1990s, high inflation. The consumer price inflation was at 10.36% for the month of April 2012. Urban inflation was at 11.1% whereas rural inflation was just below 10% at 9.86%. If Subbarao goes about cutting the repo rate in a rapid manner, he runs the danger of inciting further inflation.
So the only way out of this mess is to cut subsidies. Cut fuel subsidies. Cut fertilizer subsidies. This of course would mean higher prices in the short term, particularly if diesel prices are raised. An increase in the price of diesel will immediately lead to higher inflation, given that diesel is the major transport fuel, and any increase in its price is passed onto the consumers. The government thus has to make a choice whether it wants high interest rates for the long term or high inflation for the short term. It need not be said it will be a politically difficult decision to make.
Over the longer term it also needs to figure out how to bring more Indians under the tax ambit and lower the portion of the “black” economy in the overall economy. (You can read this in detail here: It’s not Greece: Cong policies responsible for rupee crashhttp://www.firstpost.com/economy/dont-blame-greece-cong-policies-responsible-for-rupees-crash-318280.html)
And there is nothing that RBI can do on any of these fronts. The predicament of the RBI was best explained in a recent column titled Seeking Divine Intervention, written by Rajeev Malik, an economist at CLSA. He said: “There are three institutions that keep India running: the Supreme Court, the Election Commission and the Reserve Bank of India (RBI). To be sure, most of the economic mess in India has the government behind it. And often the RBI is called in as a vacuum cleaner. But even the world’s best vacuum cleaner cannot be successfully used to clean up a garbage dump.”
(The article originally appeared at www.firstpost.com on June 4,2012. http://www.firstpost.com/economy/no-subbarao-wont-be-able-to-clean-upas-garbage-dump-331114.html)
(Vivek Kaul is a writer and can be reached at [email protected])