Financial markets are waking up to the possibility of the RBI lowering rates later in the year.
Inflation is inching up, the RBI is on the warpath, interest rates are tightening and company profits are beginning to disappoint. Despite all this, I sense a shift in the mood of our financial markets — from one of utter gloom to very cautious optimism. For a while, asset markets seemed to be drowned in a flood of bad news. They now seem to have returned to doing what they are meant to — look beyond the present and try to price in the future. The future, it appears, does not seem as bleak as the current flow of data and news would suggest.
A number of things could be responsible for this turn in mood. The sharp decline in prices of oil and other commodities has quite obviously lifted spirits. It might be interesting to figure out exactly why. Markets are used to the idea of recession. What bothered them for much of the first half of 2008 was a twist in the plot — the fact that instead of pushing inflation down, the prospect of a sharp slowdown in the world economy came with a dose of high inflation. As the confusion about what was the bigger problem — slowing growth or high inflation — multiplied, risk aversion grew and markets sold off.
The prospect of stable if not lower commodity prices is helping to clear some of this confusion. The implication is that if the current business cycle goes back to a textbook template, the task of macroeconomic management becomes more clearly defined. Instead of toggling between the conflicting objectives of reining in inflation and propping up growth, governments and central banks can now focus exclusively on fighting the slowdown. Markets like this clarity.
In short, financial markets are not expecting a sudden reversal in the business cycle. Apart from the pathological contrarian, most market analysts are convinced that the next few quarters could see declining growth. What brings a glimmer of hope is the possibility that if commodity inflation abates, macroeconomic policy can now address this slowdown squarely without bothering about the inflationary consequences.
Let me make this less abstract and discuss the implications for India. If commodity prices stabilise globally, the effect is likely to seep into local headline inflation a few months from now. Thus while the inflation rate measured year-on-year could continue to move up, the rate of increase in prices month-on-month could slowly diminish. Thus, it is possible that the inflation rate will reach a peak of 12-13 per cent by October and then start moving down.
Banks have taken cues from the recent moves by the RBI and are hiking rates aggressively. This is bound to take a toll on credit demand and growth and my sense is that by the last quarter of 2008, most bottom-up indicators of economic activity would signal a palpable moderation. Companies’ bottom line will have sagged by then and analysts will start to pare their forecasts for the future considerably.
What does the RBI do if this situation indeed emerges? There are a couple of clues that the recent monetary policy statement provides. Let me quote two sentences from the policy. In the section on the stance of monetary policy, it says, “Slower growth in demand may temper commodity prices and ultimately inflationary pressures; however, the manner and period over which this adjustment would take place is highly uncertain.” A couple of paragraphs later, it says “while modulation of aggregate demand assumes crucial importance, it is also necessary to nurture and consolidate the recent gains in augmenting supply capacities and improvements in productivity and efficiency which accrue over a longer term horizon”.
What could the central bank mean by this? My take is that if the current trend in commodity prices sustains and there are growing indications that the monetary squeeze is hurting investment spending in the economy, the RBI could reverse monetary policy. It would first switch to a “neutral” stance and take a pause in hiking rates. It would then, depending on the degree of the growth slowdown, contemplate a reversal of the interest rate cycle. It is possible that by the end of this year or by early next year, the RBI starts paring interest rates or lowering reserve requirements. My assessment is that financial markets, particularly the bond market, are beginning to wake up to this possibility. The stock markets might need more to be convinced, but once they sense that interest rates are close to their peak, fear could easily give way to greed.
The other bit that is helping the markets seem to regain their confidence is the fact that the dollar is regaining some of the strength that it had lost against major currencies like the euro and pound over the past year. My understanding is that the health of the American currency is critical to global risk appetite the world over. A wobbly dollar is bad for riskier asset classes like emerging market equities and debt. This includes Indian equity and debt assets. A stronger dollar is a very basic signal that the world’s leading growth engine, the US economy, is on a path of recovery (however long that might take). This gives investors confidence.
It would be frivolous not to emphasise the associated risks. The US financial system is still not out of the woods and a couple of nasty shocks in the US banking system could send investors scurrying back to commodities. Local demand shocks in India could send prices of things like food soaring and the RBI might not want to relax its grip too quickly. However, the balance of risk and rewards seems a little more favourable now for asset markets.
The author is chief economist, HDFC Bank. The views here are personal
