The global financial markets are in a very peculiar state. The volatility index, VIX, is at its quietest. Inflation is low, and below the target value of 2%. Growth is low as well by historical standards, but it is higher than it was five years ago. In the euro zone especially, the revival of growth has been the slowest in coming, but it is here.
The Federal Reserve has increased its rate twice this year by 25 basis points. It is thinking aloud about one more increase this year. The Labour market is tight and though the growth rate is not spectacular (around 2%), the Fed thinks ahead of the curve and wants to ensure that it is not surprised. It is also thinking about tapering. Doing so will depress bond prices and increase bond yields. If there is a need for higher rates, then tapering would be the right thing to proceed with. The Fed is again being cautious in the pace of tapering. It does not want a collapse in the bond prices just to get its balance-sheet looking healthier. Nor does it want to have to reverse its policy either way. Thus, the pace of tapering, as and when it happens, is crucial.
In thinking explicitly and openly about tapering, the Fed is setting an exemplary tradition in transparency and preparing the markets. Other central banks are more old-fashioned, treating any frank and open remarks by the central bank leader as a breach of tradition. This leads to perverse problems. Mark Carney, the Bank of England (BoE) Governor, had ruled out any increase in rates arguing that the UK economy was not anywhere near as tight as the US economy. Even so, there is an argument going on within the BoE as to when, not if the rates would go up. Similar situation prevails in the Eurozone. Mario Draghi had been signalling caution.
But the situation is febrile whatever the VIX may say. People recall that while central banks worried about price stability, it was (the lack of) financial stability which caused the crash in 2008. The Phillips Curve may say one thing but financial stability dictates something else. This was seen last Thursday in the bond markets. At a meeting in Portugal, Draghi seemed to add some sunshine to his usual stance. Mark Carney also reversed his position and said rates could go up. This caused an unseemly dumping of bonds.
The markets know that the long period of low rates has to end sometime. No one knows however when the turn may come. Hence, the nervousness. There was also some over-interpretation of what was being said. Draghi ended his speech in Portugal with his usual caution. But by then the journalists had already retailed the bullish views he expressed in the early parts of his speech. Smartphones rushed the news to the market, and mayhem followed.
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What all this means is that financial stability cannot be taken for granted. Central banks have to communicate more openly and more often as to when they may raise rates, and even more important, when they may start tapering. For about 30 years after Paul Volcker changed the course of monetary policy and raised rates sharply to control inflation, central banks worried only about price stability. They speak lately of macro-prudential stability, but markets are jittery despite their talk.
The problem is that while the monetarists had a theory of inflation, and the Phillips Curve was fashioned into a tool, no one has modelled financial stability with the same assurance. In 2008, we realised that we know little about the dynamics of financial stability. The extreme reaction in the bond markets tells us that there is a deep fear of a repeat of 2008. No one can model or predict when the next crash will come as come it must. While QE was being undertaken, no one gave much thought of how it would be reversed. The banks and corporations are flush with the money they got for the bonds they unloaded. They are holding on to the cash or have invested them in assets which can give them a decent yield, i.e, in riskier assets. Central banks have to take the markets along with them when they taper.
A rise in rates in the G7 will affect many emerging economy corporates who have borrowed freely abroad while rates were low. This is the biggest danger to India and other developing countries which could grow faster, thanks to the dollar loans. If, however, the central banks of the rich countries refuse to heed the needs of the Third World, then heaven help us. We could get into a replay of the Asian crisis of 1997-99 due to rising interest rates and corporate defaults from the developing countries. We need more communication, more deep analysis and closer coordination across the globe to avert the possibility of a second meltdown in 12 years.