The making of another storm

A rapid rise in the number of new Covid-19 cases has increased risks for economic recovery. Hopefully, the spread will be contained quickly and not significantly affect economic activity. But the virus is not the only challenge for Indian policymakers. Evolving conditions in both domestic and international markets can materially increase policy complexities. The latest monthly bulletin of the Reserve Bank of India (RBI), for instance, argued that “bond vigilantes” could undermine the recovery. It further noted that the RBI “is striving to ensure an orderly evolution of the yield curve, but it takes two to tango and forestall a tandav.”

Bond yields have risen in recent weeks and a higher cost of money can indeed impair the recovery process. But the RBI’s assessment looks somewhat exaggerated. Yields are rising because of fundamental reasons and the central bank shouldn’t be surprised. Government borrowing has increased significantly and is likely to remain elevated in the foreseeable future. Besides, inflation remains a risk. Core inflation inched up to 6 per cent in February and rising commodity prices might push up the headline rate once again.

It is also worth noting that India is not the only market where borrowing costs are rising. Yields on 10-year US government bonds have risen by over 100 basis points from the lows of 2020. Higher yields in the US will have implications for the global financial system, including Indian markets. There are concerns that the additional fiscal stimulus worth $1.9 trillion could push up prices. Economist Lawrence Summers in a recent article in The Washington Post, for instance, noted: “...there is a chance that macroeconomic stimulus on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation.”

But the US Federal Reserve is not worried at the moment. Fed Chairman Jerome Powell believes that any increase in prices would be temporary. 

Mr Powell has reasons to be not concerned. Inflation has remained mostly below the 2 per cent target since the financial crisis of 2007-08. Additionally, the Fed is willing to allow it go over 2 per cent for some time to compensate for lower prices over the years. This could create more uncertainty in financial markets. It may not be obvious to markets at what point the Fed would act and how. Besides, what if inflation actually goes above the Fed’s tolerance level considerably. The Fed has nearly doubled its balance sheet over the last year and continues to buy assets to keep the borrowing cost low. The latest forecast by the members of the Federal Reserve Board shows that the US economy is expected to grow by 6.5 per cent in 2021, compared to its December projection of 4.2 per cent. It is possible that a massive fiscal stimulus, supported by excessive monetary accommodation, results in higher inflation along with higher growth.

Since the scale of fiscal intervention is being compared to World War II, it’s worth looking at the outcomes. The Federal Reserve Bank of St. Louis in a note last year highlighted that the Fed capped yields in 1942 to keep the borrowing cost low. As the deficit kept expanding, the Fed kept accumulating government bonds. By 1947, inflation rose to over 17 per cent. Yield targeting was eventually abandoned by a Fed-Treasury accord in 1951 after inflation went over 20 per cent. True, it’s not necessary that inflation would rise in a similar fashion. Yield targeting in Japan since 2016, for instance, has not resulted in higher prices. But inflation outcomes akin to Japan could lead to bigger problems for the US and the rest of the world!

Evidently, the outlook is fairly uncertain, which is making the bond market jittery. However, what is certain is that the US will grow at a significantly faster rate compared to the earlier forecasts, which might have its own implications. Higher growth in the US, for example, would attract capital flows and strengthen the US dollar. This could hastily tighten financial conditions in the rest of the world and lead to growth and financial stability risks. Emerging markets with large short-term dollar-denominated debt could face higher risks. 

To be sure, India is in a much better position compared to the taper tantrum episode of 2013. The RBI did well in 2020 to absorb excess foreign flows to build reserves, which, in turn, will help contain volatility on the external front. However, normalisation of bond yields in the US will affect capital flows and borrowing costs in India as well. In terms of macroeconomic stability, India’s fiscal position remains a weak link. Higher growth in the US could also impact commodity prices and push up inflation. Therefore, the RBI will have to deal with multiple challenges. It will need to contain volatility in the currency market, handle a significantly large government borrowing programme, guard against inflationary pressures, and nurture economic recovery.

These ends can easily become conflicting in the coming months, depending on international and domestic economic conditions. Consider this: According to the data compiled by economist Robert Shiller, 10-year US government bond yields have averaged about 4.5 per cent since 1871. Although yields have been comparatively low in recent years because of lower inflation, a massive fiscal stimulus, rapidly expanding central bank balance sheet, pent-up demand, and a strong household balance sheet packed with forced savings can change things materially. All this could lead to a real global financial market tandav.