By postponing the rate hike, the Fed has enhanced the dangers of another crash
So, the Fed chickened out, after all the debates and discussions. We are invited to wait for the next time, when, once again, the same procedure will be gone through. Fed chair Janet Yellen and her colleagues have proved risk-averse though the risk was quite small. Once again lessons of 2008 have not been learnt. In the years preceding the crash, the Fed and other central banks concentrated on the inflation-unemployment trade-off. The Taylor Rule (a sort of ‘born again’ Phillips Curve) was invoked to increase interest rates way back in 2006, on the grounds of inflation fears.
What the central bankers missed was that manipulating the rate of interest to stem inflation may have assured price stability, but it did nothing to guarantee financial stability. The Fed, under Alan Greenspan, had kept the interest rate low for a very long time. This sowed the seeds of financial instability. There was a bubble in the housing market with sub-prime mortgages and M&A activities with outrageous valuations. The crash, when it came, did a lot of damage to the real economy as much as to the financial system. Yet again the Fed has invoked problems of flow variables, income and unemployment, rather than stock variables such as high level of household indebtedness, bubble in equity markets and, once again, M&A valuations, which make no sense. ( The latest one being the purchase of SAB Miller by ABInBev.) By postponing the rate hike—even a modest 0.25%—the Fed has enhanced the dangers of another crash. Let us hope I am wrong, but we have had nearly seven years of QE, zero interest rates in developed economy markets and excess liquidity.
In the previous crisis, it was the Western developed economies that behaved in an irresponsible way, failing to regulate their financial systems. The Asian and other emerging economies regulated their markets successfully though they violated IMF norms. This time, we have seen China suffering from a burst bubble in the Shanghai stock market. The country has also invited doubts about the accuracy of its growth statistics and its failure to communicate the purpose behind its exchange rate depreciation. There is speculation about whether China will export its (growth) recession westwards. There is noticeable capital flow out of China and the falling commodity prices have affected all the economies which thrived on exporting to China.
India has, of course, done well in the light of recent events. The Fed’s non-action will help the rupee stay stable. The case for an interest rate cut can be decided purely on domestic grounds rather than as a reaction to Fed moves. The inflation outlook is confusing what with WPI, CPI and the GDP deflator telling different stories. The problem here is that the WPI may be more relevant for business decisions while it is CPI which worries politicians since consumer-citizens are sensitive to inflation. The GDP deflator, in my view, is an academic measure, and perhaps less reliable than the other two. India also has a problem about the credibility of its GDP growth measure, one that refuses to go away. Even so, India may be an oasis of calm in the present troubled scene.
Elsewhere in the emerging economies, the news is not good. Brazil is in serious trouble, as is Russia. Africa was looking like getting back again on a boom trajectory. But China has a big impact on African economies, both directly, as an investor, and indirectly, as a market for primary commodity exports. Nigerians are waiting for president-elect Muhammadu Buhari to form his Cabinet and pronounce his plans. Nigeria may yet fulfil the expectations people have long held for it. It is large enough to be able to rely on domestic markets and not worry about the commodity price recession. But it is early days.
So, the picture is mixed. The US and the UK have recovered fully. The eurozone is not shrinking but not expanding by much, may be by 0.75% at the most. The migrant crisis is diverting attention from the macroeconomic situation. Of course, if Europe does absorb migrants, its demographic picture will become less gloomy. The migrants coming from Syria are educated (they all know English and are tech-savvy). They would improve growth prospects in the medium run.
In the long-run, we may all be better off but there is no doubt that the short-run prospect is one of recession. Low growth and low inflation will persist. If the Fed continues to be risk averse ,it may drag other central banks with it.
There is little chance now of central banks unravelling all the bond purchases they made under QE. We may have to wait longer for interest rates to get to realistic levels. This may make borrowers happy and bond markets buoyant. But the dreaded crisis becomes all the more likely. Take cover from the storm.
The author is a prominent economist and Labour peer