Fed holds rates, what now?

An implicit understanding has grown over the last several decades that in addition to controlling inflation, most shortcomings in real sectors and of growth can be addressed by central bank monetary policy interventions, notes Jaimini Bhagwati

In the last few years stock market indices in developed and emerging countries, propelled more by quantitative easing in several G7 economies than widespread robust growth, had reached irrationally high levels.

Investors are now better aware that limited growth in the US cannot fully compensate for continued systemic weakness in Europe and Japan and slowdown in China.

Given the extremely sharp rise in stock prices in the last 12 months in China a correction was inevitable.

Going forward, depending on the extent and nature of China’s slowdown, the negative ripple effects in Asian economies and net commodity exporters such as Brazil, Australia and Russia would be correlated with the volumes of trade, investment and portfolio flows between them and China.

It was apparent from the 2008 financial sector breakdown that the interests of investors/share-holders as opposed to those of managers do not necessarily converge.

More broadly, the divergence between the long-term interests of nations and the short-termism of corporate management responding to signals from stock markets has become ever more evident.

Finance professionals and the media cannot usually be held legally accountable for misleading investors as they are careful to caveat their prognostications. Rating agencies go one cynical step further by maintaining that their opinions are protected by freedom of speech and are merely opinions.

John Kay’s recent book Other People’s Money: The Real Business of Finance explains how finance has become more about secondary-market trading than efficient intermediation of capital.

Politics everywhere tends to be local and short-term.

However, does all economics or finance have to be short-term?

In many jurisdictions, including India, there is a close correlation between political considerations and economic decision making which focuses on the short-term.

For example, the continued lack of action on the real effective exchange rate of the rupee which is still way overvalued and higher than warranted attention to foreign portfolio investors’ interests relative to other longer term forms of investment.

The bottom line is that governments and regulators as also management in financial firms and real sector companies have become inordinately focussed on the short-term.

Andrew Haldane, currently the chief economist of the Bank of England, suggested in a May 2011 speech (titled “New Paradigms in Money and Finance?” at the 29th Société Universitaire Européene de Recherches Financières Colloquium in Brussels) that “there is statistically significant evidence of short-termism in the pricing of companies’ equities.

This is true across all industrial sectors. Moreover, there is evidence of short-termism having increased over the recent past.”

The short-termism in management decisions based on how a company’s stock is performing is also no doubt influenced by a desire to boost the value of stock options.

The so called new normal of lower growth in OECD countries could perhaps be partly attributed to an excessive focus on the quarterly performance of stocks instead of longer term profitability of real sector firms.

Haldane’s suggestions to address this short-termism predictably includes: (a) enhancing transparency including educating-persuading managers to act as per their fiduciary responsibilities; (b) raising voting rights for longer term investors; (c) making compensation for senior managers dependent on longer term performance; (d) increasing tax rates on shorter duration holdings of stocks and subsidising long-term investments both at the level of individuals and firms.

The Financial Stability Board has made well substantiated suggestions on these lines but there is little evidence that G20 nations are paying any serious attention.

An implicit understanding has grown over the last several decades that in addition to controlling inflation, most shortcomings in real sectors and of growth can be addressed by central bank monetary policy interventions.

The reality is that central banks have limited instruments at their disposal, which if used indiscriminately or too long can have unintended and even disastrous consequences.

It is surprising, therefore, that central bankers around the world as also multilateral institutions such as the World Bank and the IMF have cautioned the US Federal Reserve against raising the overnight Federal Funds rate even by 25 basis points.

This is absurd since the same countries and institutions were less than vocal when interest rates in developed countries were gradually reduced to close to zero and even negative nominal levels (in the case of the European Central Bank).

Such persistently low interest rates in G7 currencies has encouraged high volumes of “carry” trades vis-à-vis high interest rate currencies and also pushed portfolio capital flows to developing and emerging economies to unhealthily high levels.

If anything at all could be achieved through coordination, this is best done through G20 forums at the forthcoming Summit in Turkey on November 15-16.

The Federal Open Market Committee meeting of the US central bank is taking place on September 16-17.

On September 15, Brent crude oil was priced at $47 per barrel which is about 60 per cent lower than its peak price in 2014. Commodity importers such as India are in a relatively sweet spot.

Despite this observers in India have indicated their preferred outcome, namely that the Federal Reserve is not likely to raise its overnight Fed Funds benchmark interest rate -- for the first time since 2006.

Clearly, financial markets in India could take a beating if US interests were to rise.

However, this would be short-term if we get real sector policies right.

Short-termism has so permeated our thinking that too much time is spent on speculating on a 25-basis point hike in an overnight rate in the US.

As I send this article to Business Standard on September 17, the FOMC meetings are not over and a decision to raise the Fed Funds rate or not has not yet been taken.

It will be apparent once the FOMC decides whether it allowed short-term considerations to overwhelm its better judgement or not.

All things considered, it would be a sound longer term oriented decision if the Fed Funds rate were to be raised by 25 basis points.

Image: Decorated elephants walk on a street during the Elephant Festival in Jaipur. Photographs: Reuters

Jaimini Bhagwati is currently the RBI Chair Professor in ICRIER. Views expressed are personal