Diffident US and endless saga of Greece's problems

Apart from the US Federal Reserve, which is yet to make up its mind on an interest rate hike, the markets stayed on edge last week due to the endless saga of Greece's problems, explain Abheek Barua & Bidisha Ganguly.

Despite the financial markets' best efforts to get the US Federal Reserve to commit to a time and path of hiking its policy interest rate, it seems to be in no mood to oblige as its Open Market Committee policy meeting on June 16 showed.

Words such as "moderately" and "somewhat" qualified almost every observation made about economic trends in its brief communique, the classic doublespeak of a policy authority that is yet to make up its mind. 

As Fed Chairperson Janet Yellen admitted, she would have to wait for "more decisive evidence" that labour markets were healing and the economy was on the mend before hiking rates. 

To confound matters further, the Fed has revised its interest rate projections both for 2015 and 2016.

The murky economic outlook in the US might justify the Fed's ambivalence but has its risks. If the Fed's policy rate is indeed to lift off by the end of the year, the American central bank should be prepping the markets for it to avoid unnecessary volatility at the time of the hike and end its waffle. 

Mercifully, the financial markets have taken matters into their own hands and factored in rising interest rates by the last quarter of the year.

In fact, the Fed fund futures market that prices in expectations about the policy rate is building in two hikes by the end of the year. This will help rein in the volatility at the time of the hike, although some turbulence is inevitable. 

To be fair to the Fed, their inability to be more assertive in their communication stems from the fact that some of the relationships between economic variables that it could bank on in the past have broken down.

Despite a rapid drop in the unemployment rate to the current level of 5.5 per cent, wage growth and inflation remain muted.

This suggests two things. First, the new jobs created could be low productivity and earnings. 

Second, there could be the threat of entry into the labour market of a large numbers of workers who had earlier dropped out of the job-seeker pool. 

The other mystery that needs to be resolved is that despite the large fall in oil prices, US consumers did not spend this "windfall" on other things.

Retail spending might have picked up a tad recently but has been generally tepid. As a consequence, inflation still languishes below 1.5 per cent, significantly below the Fed's target of 2 per cent. 

But here's a bit on the other development that kept the markets on edge last week - the seemingly endless saga of Greece's problems.

While the first round of Greece's discussions last week ended in acrimony, it is possible that there will be some progress when the eurogroup ministers meet again this week. 

However, this is likely to be, at best, another instance of kicking the can down the road. 

The resilience of the euro to the series of breakdowns in negotiations seems to be telling us that Grexit will not be quite the apocalypse for the region as it was made out to be earlier.

One of the reasons for this could be that a substantial portion of Greece's debt service obligations is to institutions such as the European Central Bank (ECB) and the International Monetary Fund, who are better placed to absorb losses than private creditors.

Besides, most of the loans taken from them and other institutions like the European Financial Stability Fund are long- term in nature and the immediate impact of default is small.

Greece's biggest commitment for the rest of this year is to the ECB and of the order of euro 6.7 billion, small change in the bigger scheme of things. 

On the other hand, Greece needs to seriously worry about the fact that an exit from the currency union would see its peers pushing for an expulsion from the common market, the European Union.

This would mean that Greece would lose its hefty agricultural subsidies while holding on to what would essentially be monopoly money, the drachma. 

Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is Principal Economist, CII.