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US Fed says rate cut is ‘insurance’ against global slowdown….A special column by Suyash Chaudhary, Head, Fixed Income, IDFC AMC 

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Central banks, via monetary policy, ultimately aim to influence domestic financial conditions which in turn affect economic variables like growth and inflation. Interest rates are only one component of aggregate financial conditions, but probably one that central banks influence the most directly.

The other major components of this include relative currency strength, credit spreads, and equity markets. In a phase of same direction policy moves, this ability to maintain or ease relative financial conditions via monetary policy action ultimately decides whether such action has been successful or not.

The US Federal Reserve
With the Fed cut yesterday, major developed market central banks have officially begun the process of easing that some of their developing market counterparts have already embarked upon earlier in the year. Thus, the above framework of gauging policy effectiveness via relative changes in domestic financial conditions (of course, relative to domestic economic and stability conditions) is a useful way of both monitoring effectiveness of easing, as well as in trying to predict the future path of easing for the particular central bank.

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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 prima facie merely reverting to its more sustainable trend rate of growth of around (or just under) two per cent from the fiscal stimulus fuelled trend of around three per cent last year.

The consumer is doing well and unemployment rate is very low. Enough jobs are being added, thus far, to maintain these low levels of unemployment. Under such circumstances, it was always going to be tricky for the Fed to conform to the market’s expectations of multiple rate cuts without a somewhat bleaker assessment of the economy. This kind of an assessment may then have caused damage via the confidence channel. More fundamentally, it may genuinely not be in consonance with the Fed’s honest economic assessment.

Under the circumstances it did the best it could, justifying the cut on the basis of the global slowdown (particularly in Euro and Chinese manufacturing), trade related uncertainties, slower than desired US inflation, and a somewhat lower than earlier estimated so-called neutral policy rate. Within US growth dynamics as well, there is a recognition of the slowing manufacturing and business investment part of the economy.

In the press conference post the meet, the Fed Chair described the cut as a mid-cycle “insurance” cut in order to make sure that the recovery prolongs in the face of global and trade related headwinds and also to give support to inflation. In particular, he was focused 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 basis points (bps).

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Indeed, when looked at this way, and remembering some of the major components of aggregate financial conditions, while over this period the US dollar hasn’t done much, interest rates are substantially lower, credit spread expansion late last year has been arrested and equity markets have largely held. Thus, it could be argued that financial conditions have loosened in the US over the past few months, thus helping to sustain the recovery — a point that the Fed Chair mentioned more than once.

The problem, of course, is with respect to forward guidance. After a long time, there is next to none, barring an impression given that the market shouldn’t expect a series of cuts. If the somewhat underwhelming Fed meet yesterday leads to incremental significant tightening of financial conditions relative to strength of incoming US data, and given the prospective actions of other central banks, then it is likely that markets will start leading the Fed again. This, if it happens, will be evidenced in a resumption of curve flattening.

The European Central Bank (ECB)
As against the Fed, the ECB is facing a more dire economic situation and, it may be argued, has potentially a weaker tool kit to address it with. 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. he need for action is, thus, clear and some of it has already started in terms of guidance and proposed resumption of long-term refinancing operations.

The main deposit rate for ECB, however, is already negative and there are some constraints to further meaningful expansion of quantitative easing (some of which may be surmountable via court rulings). There is obviously the related question of the incremental utility of further quantitative easing (QE) expansion. This is because at least one major intended outcome of QE is to bring down long term rates. But in a world where large swathes of long-term rates are already near zero or indeed negative, one wonders how far this effect of QE has to run.

Given the situation, the big question with respect to ECB is not whether they will ease, but whether such easing will be effective enough to materially ease their relative domestic financial conditions. On the margin, a perceived relatively hawkish Fed is somewhat of an unintended ally for the ECB, in so far as it helps weaken the Euro and eases relative financial conditions in the Eurozone. However, too much of this relative easing may restart concerns at the Fed towards relative tightening of their financial conditions, thereby impacting future US monetary policy decisions!

While we have dwelled on only the two major central banks, other significant geographies are also experiencing their own shares of growth pangs and associated easing expectations. China is notable where some of the new incoming data is weakening again, particularly with respect to industrial profits. Further, stresses in the financial system are also increasingly more evident.

The Case of India

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The narrative we are most used to in India in episodes of global slowdown is that the domestic economy is robust and our external linkages are relatively fewer. Unfortunately, this doesn’t appear to be true in the current case. Thus, while the manufacturing slowdown here is consistent with the global manufacturing slowdown underway, we have another issue which is more local — that of the slowing consumer.

The best sequence that explains this slowdown is the fact that income growth in India has anyway been weak for the past few years. However, consumption has been sustained via rising consumer leverage. This is consistent with both the aggressive growth in consumer-facing lending books over the past few years, as well as the noticeable dip in total household savings over the period.

With the housing and non-bank finance lending squeeze underway for the past almost a year now, the leverage effect for the consumer may be slowing. There may be a behavioural aspect here as well, where with savings already dipping and the incremental environment turning weaker, the consumer is deciding to cut back. As others have noted before, since this slowdown is backed by a substantial fall-off in savings, it becomes that much more difficult to reverse in short order.

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 Finance Minister has been prudent in not administering any incremental stimulus. Not just that, she has actually hiked indirect taxes to fill some of the gap.

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It is to be remembered that the discussion here is of flow and not stock. Thus, the annual combined deficit when the Centre (on and off balance sheet) and states are added is a hefty 8-9 per cent of GDP. However, growth has slowed despite this. Put another way, this deficit isn’t in response to a growth slowdown. That growth has slowed irrespective probably testifies to the complete lack of drivers in the private sector over the past few years. The point to note is that there has been no incremental fiscal expansion undertaken in response to the last leg of deterioration in growth.

Given this, the role of the other discretionary policy pillar — monetary policy — consequently becomes stronger. As noted before, the RBI’s monetary policy committee (MPC) is already easing via all the three tools at its disposal: guidance, liquidity, and rates. Indeed, this is for the first in recent memory that all three are being used in synchronicity. In particular, the role of liquidity is often under-appreciated, especially in context of bringing down term spreads at the front end of the curve.

With the current local and global backdrop, and with obvious constraints on fiscal policy, 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.

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