The post financial crisis world is a weird one—the world’s biggest economy doesn’t do well and the stock market rallies in another part of the world.
The gross domestic product(GDP) of United States grew by 0.2% for the period January to March 2015. This was an advance estimate released by the Bureau of Economic Analysis. The second estimate is scheduled to be released on May 29, later this month.
The BSE Sensex rose by 479.28 points or 1.77% to close at 27,490.59 points yesterday (May 4, 2015). A possible explanation lies in the fact that the bad economic growth number might force the Federal Reserve of United States, the American central bank, to go in for another round of money printing or quantitative easing (QE), as the economists like to call it.
As Albert Edwards of Societe Generale writes in his latest research note: “The US economy is struggling and the Fed will ultimately re-engage the QE spigot.” The Federal Reserve has already carried out three rounds of money printing, with the last round better known as QE III ending in October 2014. Until October 2014, the Federal Reserve had been printing money and pumping money into the financial system by buying government bonds and mortgaged backed securities.
The idea was to flood the financial system with money by buying bonds and drive down interest rates. At lower interest rates, people were more likely to borrow and spend money. This would help businesses and in turn, the overall economy. While this happened to some extent, what also happened was that institutional investors borrowed money at low interest rates and invested them in financial markets all over the world. This led to stock market rallies all over the world.
With the US GDP growing by just 0.2%, it is more than likely that the Federal Reserve will go back to its tried and tested strategy of printing money in the days to come. This round of money printing will be referred to as QE IV. What makes the situation more than likely is the fact that even a 0.2% economic growth is overstated. This is primarily because it includes a huge inventory build up. Inventory essentially refers to goods which are being produced but not being sold.
Inventories during the period January and March 2015 went up by $110.3 billion. They had risen by $80 billion during the period October to December 2014. An increase in inventory adds to the GDP. Nevertheless what it also means is that there will be production cuts in the months to come, which in turn will pull the GDP down.
Edwards of Societe Generale estimates that without this unprecedented rise in inventories, “GDP would rather have declined by some 2½%!” Economists at Bloomberg estimate that: “inventory rise added 74 basis points to growth, which means that final sales (GDP ex-inventories) actually contracted (-0.5 percent).” One of the reasons for this rise in inventory is the strong dollar, which has led to imports flooding the United States.
Another reason put forward by American economists for the build up of inventory is the more than usual ‘snowy’ winter in large parts of the United States. Nevertheless as Edwards argues: “Sales are declining on a year on year basis, but we are assured this is due to the cold weather. But if it is not, and sales do not surge in coming months, then the economy is heading into recession as the inventory sales ratio has now reached levels that will necessitate savage cutbacks in production.”
What also does not help is a slowdown in consumer spending. During the period January and March 2015, consumer spending rose by 1.9%. It had grown by 4.4% in the period October to December 2014.
The next meeting of the Federal Open Market Committee (FOMC) of the Federal Reserve is scheduled on June 16-17, 2015. It had been suggested earlier that the FOMC will start raising the federal funds rate in June. The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank, on an overnight basis and acts as a sort of benchmark for short and medium term loans. Federal funds rate is currently in the range of 0-0.25% and is likely to continue staying in that range.
With the US economic growth collapsing during the first three months of the year, there is no way the FOMC will start raising the federal funds rate in June. What this also means is that money will continue to be available at low interest rates for institutional investors to borrow and invest in financial markets all over the world. The Sensex rising by around 480 points yesterday was an indication of the same.
Also, one of the things that I have learnt in the post financial crisis world is that central banks seem to have come around to the belief that the only economic weapon they have to get economic growth going again is to print money. Given this, QE IV might well be on the cards in the days to come. And this means foreign institutional investors will continue to invest money in Indian stocks.
All I can say as of now is stay tuned and watch this space.
The column appeared on The Daily Reckoning on May 5, 2015.