Monetary policy, productivity, and fiscal policy: This time it is different!

28 Oct 2024 , 12:00 PM

The legendary Sir John Templeton famously said that, “In the world of investments, the 4 most dangerous words were – This Time It’s Different.” However, that is what the MF report on the World Economic Outlook in October 2024 appears to be saying. The growth and inflation are getting back to normal levels, but a lot has changed. Here is quick dekko on the big shifts in global macros, global monetary policy, and global fiscal policy.

1) DISINFLATION TO SEE BUMPS ALONG THE WAY

The story of inflation in the last 2 years has been of central banks tightening rates to control the highest level of inflation in the last 41 years and a wide disparity in growth recovery. If the disinflation appears to have worked till now, the road ahead may be full of bumps. Why does the IMF say so? Firstly, in many of the advanced economies, the disinflation has come at a relatively low cost to employment. Normally, when the rates are tightened sharply and rapidly (as it happened in 2022 and 2023), the GDP growth rate falls and joblessness is on the rise. That hard landing did not happen; on account of two key factors. Firstly, energy prices remained well in control and secondly a rebound in labour supply was bolstered by substantial immigration flows; which were more like a self-adjusting mechanism. In short, for all the advanced economies, the Sacrifice Ratio was quite low.

If inflation was misaligned for large parts of 2022 and 2023, the situation has changed since the start of 2024, when the inflation across most of the advanced economies has shown a tendency to get into sync. Disinflation has continued broadly as expected but there are signals that there could be hurdles along the way. For example, inflation in most of the advanced economies continues to be cyclical and prone to sharp fluctuations. Secondly, core inflation had been the key driver of lower headline inflation but that appears to have bottomed out now. The reason is quite simple. The spike in core inflation had been caused by supply chain bottlenecks and that was being automatically rectified as the supply chains normalized. Going ahead, the core inflation promises to be flat to higher as compared to the current levels. One more point to note is that most of the fall in inflation has been driven by goods; while services inflation continues to be elevated. Currently, the core services inflation globally is at 4.2%; a good 50% higher than the pre-pandemic levels.

What does the recalcitrance of core services inflation at around 4.2% indicate? Firstly, this is in stark contrast to the core goods inflation, which is now close to zero levels. That is up in recent months, but only because the geopolitical crisis in West Asia and the blockade of the Red Sea has imposed an additional cost on shipping and insurance. That has slightly pushed up the core goods inflation. The one interpretation for higher services inflation is the higher nominal wage growth relative to the trends seen prior to the pandemic. Clearly, wage negotiations in the last few years have factored in much higher cost inflation as evidenced during the 2021-2022 period.

That brings us to the million dollar question; will the current bout of disinflation continue? The first question is whether the recent spike in labour and input costs will be absorbed by the companies or passed on to end customers. In the latter case, it will be inflationary. The second question is whether the higher wages would be accompanied by higher productivity or not? In the former case, it will not be inflationary but in the latter case, it would be inflationary. On this subject, the global experienced of the advanced nations has been mixed. For example, the US saw wage growth that was reflective of productivity gains. On the other hand, in the case of EU Zone, the rise in wages were not accompanied by gains in productivity. This will have a major bearing on disinflation, going ahead.

2) PARADIGM OF MONETARILY TIGHT, BUT FISCALLY LOOSE

This trend has been quite vivid in the last few quarters, across most of the advanced economies and also the emerging economies. In the immediate aftermath of the pandemic, there was monetary and fiscal easing. Central banks kept rates low or very close to zero while the government opened the fiscal taps to boost consumer spending. A lot of helicopter money was thrown around to revive spending and growth. However, since the early part of 2022, there has been a new paradigm in place; of being fiscally loose but monetarily tight. This has a number of implications.

Tighter monetary policies mean that people are paying more for credit cards, consumer loans and even for home loans. That has contributed to weak demand for housing in the US, although that is expected to change with the rates now being cut since the September 2024 monetary policy and more cuts on the anvil till the end of 2025. There was another dichotomy that was visible. As the interest rates in the US and other parts of the world were increased to deal with inflation, it first brought down the inflation expectations and then it brought down inflation. However, this created a piquant situation for the investors in particular and the markets in general. The higher rates and lower inflation expectations resulted in a sharp fall in the real rates of interest. The real rates in most countries are now well above the pre-pandemic rates and it is not exactly a sustainable scenario. It remains to be seen when this tight monetary and loose fiscal policy gets reversed.

One of the key trends we got to see in the US in recent months is a tight monetary policy combined with a loose fiscal policy. What is more interesting, according to the IMF WEO report is that this combination of tight monetary policy combined with relatively loose fiscal policy, may be one of the key factors that has led to dollar appreciation in 2024. That was evident in the dollar index recently surging from the 100 levels to around 104 levels.

3) WORLD MUST PREPARE FOR TURBULENT FINANCIAL MARKETS

The IMF WEO report has cautioned that the road ahead could be marked by substantial financial market volatility and turbulence as global market and global assets classes adjust to a new set of return and risk assumptions. Let us take a case of the Indian markets in the last two months. September was a month of heavy FPI inflows and a positive market trajectory. October 2024 has been a stark contrast with record FPI selling and a sharp fall in the Indian markets. Similarly, in the US, there are several signals of turbulence. There was a GDP growth shock in the first quarter and a normalization in the second quarter. There was also a job shock in July and August, before normalizing. Add to that, the external factors like sell-off in the Euro, post ECB rate cuts or the unwinding of yen carry trade in Japan had global repercussions. These risks are likely to have a global imprint, get transmitted across markets rapidly and impact multiple asset classes at the same time.

What is surprising about these recent bouts of volatility is that they have been largely unpredictable with little forewarning. At the same time; the turbulence has been such that markets have transitioned from stability to chaos and back to stability in a very short span of time. In the US markets, the VIX had touched the 2020 highs making the markets extremely vulnerable. Consistently low rates have made equity markets artificially valuable. The other reason for the disconnect was the huge divergence in the equity markets between price and value. One has to look at stocks like NVIDIA and other similar stocks for the kind of rally they have witnessed. Back home in India, the Buffett Ratio (ratio of market to GDP) stands at 136%, against a historical average of 91.1%. Clearly, such dichotomies are not sustainable and are bound to trigger harsh and frequent bouts of market volatility.

4) GEOPOLITICAL RISKS, YES: BUT LITTLE IMPACT ON GLOBAL TRADE

Since October 2023, when the Hamas launched a series of attacks on Israel, they have been at war. Casualties have been large and there has been collateral damage at a larger scale. The Houthi Rebels (affiliated to Iran) have virtually blocked access to the Red Sea route. For many countries like India, the passage from the Red Sea to the Mediterranean via the Suez Canal is the lifeline of trade with Europe and the US. The impact has been significant. With persistent Houthi attacks on ships passing through the route, most of the shipping companies have decided to take the much longer route through the Horn of Africa. That has meant higher freight costs, longer delivery times and higher insurance costs. But, that may be the more benign of outcomes of the geopolitical risk.

There are bigger risks to global trade flows that have manifested in recent weeks. Oil supply routes and oil prices remain under attack. The only positive factor is that oil demand is tepid and hence the oil prices have not really spiked. The global markets are apprehensive that Israel could hit key oil or nuclear installations of Iran in the near future and that could have larger repercussions. Iran may even blockade the Strait of Hormuz, recreating a situation that is almost akin to the blockade of the Suez Canal by Nasser of Egypt in 1956. However, despite these risks, the global trade in the current year is a lot more robust than last year when the risks of a global slowdown were rampant. In fact, the global trade volume as a share of world GDP have actually gone up.

However, there signals (according to the IMF WEO report) that the global trade story may be getting substantially fragmented compared to the previous occasions. What exactly does that mean? One reason for a more fragmented trade paradigm could be the current tensions on the geopolitical front. Trade is getting more regional and inter-bloc as compared to the pure cost advantage driven trade in the past. For example, one reason for the trade getting fragmented is the reduced role of China amidst the slowdown. Also, the sanctions on Russia have recalibrated oil trade flows between India and Russia, something unheard of in the old days. Another big change is that global companies are increasingly looking at a China Plus One policy which means, large chunks of the supply chain trade is likely to get distributed across Asia. Thes are interesting times and things could just about get clearer in the coming weeks and months.

5) LAST WORD ON IMF WEO – PREPARE THE WORLD FOR UNCERTAIN TIMES

It is almost like a forewarning from the October issue of the IMF – World Economic Outlook (WEO). One reason for the uncertainty could be that the IMF feels that growth in the long run may have been durably impacted by the pandemic, and its aftermath. Cycles are one part of the story, but the real concern here is the new phase of uncertainty that the global economies and the global markets are up against. Global GDP growth is likely to stay under 3% for a long time after the pandemic and the monetary policy tightness.

However, even in these uncertainties, there are several inconsistencies and dichotomies. For example, if you look at the goods prices with reference to the price of services, the ratio is much higher today than in the pre-pandemic scenario. This differential was triggered by strong demand for goods alongside supply constraints. However, there is also a global shift from consumption of goods to consumption of services globally. This rebalancing is tending to boost activity in the services sector in advanced and emerging markets but is dampening manufacturing. That is not always a good situation to have. One big outcome could be that manufacturing could now decisively and inexorably shift from advanced economies to the emerging economies on the back of higher competitive advantages.
To sum up, the IMF WEO report has lauded global central banks on managing the crisis with a higher degree of effectiveness. However, it is here that the wisdom of governments and government policies will play a larger than life role!