Financial markets in India were struck by a tsunami on June 20, 2013, with the BSE Sensex declining by a massive 526 points. The tsunami is showing no immediate signs of receding, with the Sensex continuing to tank and the rupee crossing 60 against the dollar on June 26. The provocation has been again the perceived threat emanating from the Ben Bernanke statement that QE may soon unwind. We, however, maintain that the markets may have strongly overreacted, and there may be no rationale to believe if we go purely by Fed arithmetic of any near-term threat of a QE scale down. Let us first decipher what Fed has exactly said in its May 22 and June 19 press statements. In both the statements, the Fed explicitly stated that:
(a) The federal funds rate will remain at exceptionally low levels until at least the US unemployment rate remains above 6.5%.
(b) When the committee decides to begin to remove policy accommodation (refer the monthly $85 billion asset purchases), it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2%.
(c) The committee believes that inflation between one and two years ahead is projected to be no more than a half percentage point above the 2% longer-run goal.
Taken together, what do the statements imply? The highly accommodative stance of monetary policy will remain appropriate for long, even if the asset purchase programme ends, provided economic recovery continues to strengthen in the US. Now, what does the recent data suggests?
It is clear that economic activity in the US has picked up pace since November 2012. In Q1-2013, GDP grew by 2.4% compared with 0.4% in Q4-2012 and 2% in Q1-2012. Consumer spending, which accounts for roughly two-thirds of GDP, rose 0.6% in May 2013?still lower than 1.1% in February 2013. On the downside, however, the recovery is still not broad-based, with industrial production and new housing units sold barely growing. Hence, it is almost unlikely that the US economy will recover rapidly enough to justify scaling down of bond purchases towards the end of 2013/beginning of 2014 (coinciding with end of Bernanke?s tenure in January 2014), as the market believes. If this is true, then the fear of global rebalancing of portfolio capital and hence capital flight from emerging economies may be temporary. The Fed has actually lowered its forecast for 2013 growth to 2.3-2.6%, Q1 GDP growth has been revised downwards from 2.4% to 1.8% and household purchases from 3.4% to 2.6%!
Coming back to the Fed estimate of how long the accommodative monetary policy may continue. As per Fed, it should till unemployment rate touches 6.5% from the current level at 7.6% and/or inflation rate is at 2.5%. Based on a simple extrapolation exercise, we estimated that:
(a) It may take at least 18 months from June 2013 for the US economy to touch the pre-crisis unemployment rate of 6.5% (October 2008). Alternatively, the total time taken to reach pre-crisis level will be November 2014, at the least. Interestingly, this will be the longest in the US crisis history (beginning November 1948, table 1).
(b) Based on historical trends, the average inflation was 2.5% during 2003-04. During the concomitant period, the average US unemployment rate was 5.8%. Based on our simple extrapolation exercise, this implies that by November 2015 the US could hit the unemployment level of 5.8%.
It should be noted that our exercise is based on a linear trend, and hence could be the best case estimate. In reality, as unemployment rate will move closer to 6.5%, it will take that much longer, because of the labour market downward rigidities. Whatever is the result, it is clear that only by November 2014 we may see the possibility of unemployment touching 6.5%. Hence, it is clearly a case of panic reaction by the markets, and no amount of rational exuberance may explain this!
Let us now elaborate a little bit on recent debt capital outflows from India. There is an apprehension in the market that with the yields on US bonds widening, this may trigger a portfolio debt outflow, based on existing interest differentials. Our analysis however shows that, for an extended period (January 2011-June 2013), the correlation coefficient between interest rate differential (10-year sovereign yield difference between the US and India) and FII inflows/outflows is only 0.15. This correlation coefficient improves aftermath June 2012 when RBI and the government started announcing measures to augment the FII exposure limit. However, even then the correlation coefficient is not significant if we exclude June, implying two things: what is happening in current month may be an outlier and/or there are other reasons that may be accentuating the rupee downfall!
Textbook theories suggest that the US economy at the moment is perhaps in a liquidity trap of the Keynesian variety. In such a situation, interest rates are already at the lowest levels and hence may not contribute as a key driver for promoting further investment. This perhaps may be one of the reasons for the current turmoil in the US, as QE has failed to spur investment activities. However, this, we believe, is just one line of reasoning and may be subject to debate.
Before we conclude, let us highlight that the pattern of Fed QE purchasing in the last few years has been to first scale back its bond buying, but start again with the economic data not encouraging. With our projections showings November 2014 could be the earliest data when the Fed objective of 6.5% unemployment rate may be obtained/long-term goal of maximum employment, the market bet of QE tapering off beginning 2014 may just be wishful thinking.
The author is chief economic advisor, State Bank of India. Views are personal