Business

Is there still room for softer interest rates?

A study of recent global economic developments suggests that concerns about interest rates going up, generally, may have been overdone, says T. B. Kapali

NOT FOR nothing is it said that the U.S. Federal Reserve (the U.S. central bank) has a dominating influence on the course of global financial policy. No sooner than the Fed, some time back, talked about its accommodative monetary policy coming to an end at some point, many central banks around the world were seen revising their own policy stance.

The financial markets also immediately reflected this — with exchange rates and bond yields, particularly in the emerging markets, pricing in changes in the U.S. Fed's interest rate stance.

The Fed's actual hiking of benchmark U.S. interest rates by 25 basis points on June 30 has only reinforced market perceptions about a gradual hardening of global interest rates and weaker exchange rates.

The Reserve Bank of India too has acknowledged the changes coming about in the global monetary environment. At the same time, the RBI and more strongly the Government have also said that India may not have to follow the U.S. step for step.

The domestic financial markets, though, do not seem to be much convinced. Like elsewhere in Southeast Asia, the local currency's exchange rate has come under pressure while interest rates have firmed up considerably.

The Indian rupee at around 46.40 against the U.S. dollar now is down almost 7 per cent from its March high of 43.50. Benchmark Indian interest rates — 10- year GoI bond yields — have also risen sharply to around 6.10 per cent from around 5.10 per cent a couple of months back.

Developments in the Indian financial markets, importantly though, have to be read against the dramatic political changes of the past couple of months and the resultant uncertainty about macro economic policy. The bearish sentiment surrounding the rupee and local interest rates can, to a considerable extent, be taken as politically related. Netting out these politically induced moves, one has to see if the purely economic environment affords some relief for the local currency and interest rates.

Overdone concern

A study of recent global economic developments suggests that concerns about interest rates going up, generally, may have been overdone.

For sure, a recovery is evident in the major economic blocs, namely, the U.S, the Euro zone and even in depression-hit Japan. But nowhere is the recovery so firmly established, with a self-sustaining momentum, that aggregate demand for goods and services in those economies will run ahead of aggregate supply in the short or medium term, thereby causing an upward pressure on prices. (There have been interesting exceptions — notably in the U.K. and Australia — where interest rate increases have been warranted by aggregate demand pressuring supply even in the short-run).

Job creation, consumer confidence, wage levels, consumer spending, investment and business confidence — key determinants of aggregate demand — are not uniformly rising or improving in any of the major economic zones. This has been despite some of the most aggressive fiscal and monetary stimulation measures in recent history to revive aggregate demand.

Weighed against this is the fact that the past decade has seen considerable whittling down of barriers to trade in goods and services. There are, of course, stiff obstacles to the WTO talks reaching a conclusion which may be beneficial for all participating nations. But that does not still detract from the fact that in today's world, one has to think of global supplies and capacities in not only tradable goods but also services.

Leave alone global capacities. It is a fact that in the U.S., Germany or Japan, there is considerable slack in the economy or under-utilisation of existing domestic factors of production such as capital stock or labour. Capacity utilisation levels in U.S. industry, for instance, are just touching 80 per cent. Unemployment in Germany is around 9-10 per cent.

Why prices are up

Assuming aggregate demand is running below aggregate supply, how is it that general price levels, say in the U.S. or the Euro zone, have moved up in the very recent past? Indeed, it is this slight upward tilt in the general price levels in the U.S. that has caused feverish speculation about the Fed's policy stance.

The answer lies in the fact that price level pressures in an economy are not caused by demand pull factors alone. Supply-side shocks — meaning disruptions in the supply of key goods and services that account for a notable part of total national expenditures — can also push up price levels. What happens is that the same or reduced quantity of goods and services is available only at higher price levels after a supply-price shock. The adverse effect is strengthened when commensurate reductions in the prices of other inputs — such as labour or overheads — cannot be brought about in the short term.

The recent run-up in headline price levels, generally across the world, arguably is supply-induced (led principally by stubbornly high oil prices) and not demand-led. And oil prices are stiff and rising due to a combination of political and economic factors — high uncertainty about sustained supplies from West Asia, unrestrained demand from China, developments relating to Yukos that accounts for an estimated 20 per cent of Russia's output and the speculative activities of hedge funds betting on oil prices.

Energy intensity

It is a fact that economies across the world now are less energy-intensive than they were at the time of the previous oil shocks in the early and late 1970s or even around the turn of the century in 1999-2000. But this cannot be said of countries such as India or China which in terms of energy intensity currently could be where some of the advanced Western countries were in the early 1970s or 1980s.

For instance, it is estimated that the U.S. consumes around 40 per cent less energy for each dollar of its national production (GDP) now than in the early 1970s. In other words, oil as a proportion of total national expenditures in the U.S. is now 40 per cent less. But that does not still dilute the fact that stiff oil prices can have a depressing effect on overall consumption demand in the economy.

With no sustained and appreciable pick up in job creation or income/wage levels, rising prices of key supplies such as oil pull demand down in the economy and lower output, as consumers cut down on other spending to accommodate the higher oil prices.

In more energy intensive economies such as India, sudden adverse price developments in a key consumption commodity such as oil would naturally have a stronger impact on headline inflation. (Expenditure on oil/related products accounts for 5 to 6 per cent of total national expenditure or GDP in India)

Policy response

What is the appropriate monetary policy response to supply shocks? Should it be higher interest rates to curb price pressures — at the cost of further depressing demand, output, employment and sentiment in the economy?

Or should the monetary authority be cautious and measured about using higher interest rates to tame what could be temporary price pressures? That is the big dilemma facing policy makers.

And as we head further into the year, it is quite likely that global monetary policy makers, including the Reserve Bank of India, desist from further monetary tightening or at worst, increase rates only at a very measured pace.

(The author is Associate Vice President (Treasury), ING Vysya Bank Ltd. These are purely his personal views which do not reflect those of his employer).

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