High Interest Rate Regime

 High Interest Rate Regime

High Interest Rate Phenomenon, post pandemic, globally: Since March 2022, Central Banks across the globe tightened their monetary policies, with huge increase in the policy interest rates in their scheduled monthly/ bi-monthly meetings. Unlike in 2008, when the central banks were increasing the interest rates, if at all, in fits and starts, the increase in interest rates, in the last one year, appears to follow a pattern set by the systemic central banks US Federal Reserve, ECB and BoE.  As hitherto, FED takes the lead and the other countries align themselves (45 central banks are said to have responded with an increase in their rates after FED announcements), though the pace of increase is not uniform. After increasing the fed fund rate consecutively four times by 75 bps each since May 2022, FOMC reduced the pace with an increase of 50 bps in Dec 22 followed by an increase of 25 bps. in Feb 23. While UK and ECB have reacted with an increase of 50 bps in their latest revision of policy rates, Australia and India responded with an increase of 25 bps. each. China called it a 'pause' and so is Japan, which continues to be accommodative.

Terminal Rate not yet near, but may spill over 2024? When everyone was expecting that the terminal Fed rate is round the corner, if not in the March meeting of FOMC, it might happen in June 2023, Federal Reserve Chairman Jerome Powell surprised by saying that since the economic data is stronger than expected, tightening rates further may be at a faster pace and the higher rates may stay at the top for a longer period than anticipated. The main reasons advocated by him are that the headline inflation is still much higher than target rate of 2% and the core PCE (personal consumer expenditure) is proving to be sticky. (We can find parallels in the statements issued by the other central banks' heads including RBI!). In this regard, to control inflation, the advanced economies have their battles against price rise on account of energy and tight labour conditions, unemployment issues and supply chain disruptions; emerging economies have (in addition to the concerns of AEs) the consequent effects of interest rate hike in US like USD outflows and the depreciation pressure on their currencies.

Genesis of the issue: Though everyone might be tempted to point out the Russia-Ukraine War from Feb 2022, leading to supply chain disruptions in commodities, as the start point for the uncontrolled global inflation levels, the prolonged huge stimulus spending packages by each government in their country, which was meant to cushion against the economic fallout arising out of COVID Pandemic, have ended reportedly in stoking up demand. One example is, the FED Balance Sheet size at USD 8.33 trillion is even now twice the pre-pandemic size of USD 4.15 trillion. 

Central Banks' Dilemma: Though the central banks know that inflation is on its way down in their countries, the rates are much in excess of the target rates set by them for ensuring price stability. They are unable to gauge when to slow, pause or ease. They want to err on the cautious side and do more and not less, fearing that any signs of complacency might flare up prices and inflation. And they will be blamed for that. Due to these reasons, while one can expect the end of an upward interest rates curve to stop sometime before September 2023, the high rates may remain 'paused' for a long time to come. (at least till June 2024)

Issues to be answered: 

1. Raising policy rate, which in effect increase the cost of borrowing to produce/consume and brings down the demand and the price levels ultimately, is only one of the tools to control inflation. Unless the fiscal measures go along, the increased interest rates may play a spoil sport on the economy and the financial system of different countries. 

2. Are the set inflation targets sacrosanct? In the present scenario of financial regionalization and fragmental global payment system taking precedence over globalization, should not the central banks' revisit their target rates on inflation? Is medium term growth not equally important like price stability in emerging economies? 

3. When interest rates move up 500 bps from zero in a year, an accident was waiting to happen somewhere," the Kotak Mahindra Bank Chief Executive Officer Uday Kotak, on the fallout of SVB. Is it a reminder to the central banks to understand that unmindful interest rises may only become counter-productive, as the internal accruals with the borrowers for sustaining or expanding will dwindle down with every paisa increase in financial costs?

Regards

To 

V. Viswanathan

12th March 2023

The above write up was posted by me for discussion to a group of senior bankers. Healthy discussions and counters took place. Two questions and answers thereto are shared below:

Question 1: What do you think MPC will do, when they meet in first week of April 23 for review of policy rate?

 My reply: Examples for ' dilemma ' are many. One current example might be the position of a member of MPC (Monetary Policy Committee). 

1. He knows that increasing interest rates continuously in 60 days intervals for the seventh time in a row means difficulty for the industry, economy and banks.  

2. But he has a mandate that he should keep the inflation within the band of 4 +/- 2% (2-6%). He has to explain to the Parliament again as to why he could not control inflation, as he did last year, if the inflation is not controlled in sep-dec 22, jan-mar 23 and april-june 23 quarters. Last year he cited COVID livelihood paralysis and post Russia-Ukraine War. This year - what he will explain? 

3. He also missed the bus, when the target rate for inflation was due for review, by choosing the same target levels. 

LIKELY : So unless inflation falls below the upper band (6%) for atleast 3 months continuously, (jan & feb were 6.52 and 6.44 respectively) he may not be confident to 'pause' the rate, leave alone reducing the rate. 

Three Choices: Since his mandate is to maintain price stabily by taming inflation, he has three choices.

a. Increase the rate again to be safer (As RBI Governor said 'avoid costly error')

b. Press 'pause' button in the hope that inflation will be within 6% in the april-june quarter.

c. Write for reviewing the inflation target rate upwards with an understanding that the present target can be pushed for 2024-25 (like fiscal deficit revised every year)

Let us wait and see what Fed does first and RBI MPC after that. 

 Question 2 :How the Indian government could have helpedthrough fiscal measures.

 My Reply: Possibly two openings should have been used during the current FY.

1. Crude oil prices which shot upto USD 120 per barrel levels in June 22 steadily declined and is at less than USD 90 atleast for the last six months. Except the excise duty of Rs.8 on petrol and Rs.6 on diesel reduced by the government in May 22, there is no revision in the retail fuel prices. The government should persuade the major oil companies to pass on the benefit of lower crude oil prices to the consumers which include passenger and commercial vehicles, tractors used in agei sector, major plants, etc. This will result in less costs in production and prices will ultimately down.

2. The expectation is that direct and indirect taxes may overshoot the budget by 35% in the current FY. The government could have attempted to reduce fiscal deficit atleast by a few basis points/reduced their borrowings from the market by a few thousand crores. This would have created positive sentiments

The following is always said. Increae capex to create more infra land employment opportunities. And this has been done in this budget and results can be seen in the next FY.

Viswanathan

20th March 2023