Globally we are seeing bond yields rise be it US, be it Japan, be it Germany as well and India too. Why do you think it is rising? Is it just pure inflationary fears?
Yes it is definitely the fear that central bankers are going to let inflation drip and that they are succeeding in doing so. Bond investors are looking at commodity prices and overall asset prices in general. In the last 10 years or so, central banks’ monetary policies have boosted asset prices but not commodities and even general inflation but this time because commodities are rebounding in a big way including food prices, bond investors are worried that general inflation must be on its way. In that sense, they are more worried that the central bankers are deliberately going to let inflation run well ahead of their targets and naturally fixed income investors are going to be affected in real terms. That is the real reason. Actually it is a fear that central bankers are actually succeeding in their mission.
This is contradictory. Fed’s Jerome Powell has many times vowed to keep the monetary policy accommodative. When do you see the Fed normalising liquidity or monetary policy?
So why do you find this contradictory in the first place?
Because while the markets are fearing that perhaps the interest rate trajectory is going to change and low rates, easy money will cease while the Fed’s promise has been on the contrary.
No I think they are not contradictory. Their fear is not that the Fed will change course and start to target inflation and bring it down. that is not their fear. Their fear is that the Fed will remain accommodative even as inflation rises.
In an ideal world, the inflation does not rise too much beyond 2% and the Fed stays accommodative. All these years, the federation markets were very happy that the central banks had remained accommodative. General inflation did not pick up and they had the best of all worlds. But now, central bankers are accommodative and planning to remain accommodative for a long term.
At the same time, the fear is general inflation is going to come back. So they are not worried that the central bankers will taper or even threaten to do a taper like in 2013. This time the bond markets were throwing tantrums because central bankers were not tapering. It is a non-taper tantrum, not the taper tantrum.
You asked are the inflation fears unfounded. I would argue that the non-taper fear is unfounded because it does require a sustained pick up in wage growth in order to drive inflation forward into a much higher level around 3% or 4% or 5% in the United States for example. We are not there yet. I still believe that a generalised inflation pick up is coming but that is not until the second half of this decade.
If we talk about emerging market and the flows, especially to India in 2021, how do you see that shaping up? We have been riding the wave. What will the rise in US yields mean for that interest rate differential with India, the debt flows to India?
The rise in yield would be temporary. If it indeed became a sustained rise and central bankers are powerless to stem it, then it would create such a big mayhem in all asset markets in the developed world that the consequences would be quite calamitous for the global financial markets. Then all bets and discussion on capital flows, etc, would be off. If this is a slow moving train wreck, eventually by 2030 we might see a new global monetary regime happening but it is not going to happen overnight.
This time around, they are going to double down on their liquidity management policies and temporarily staunch the blood bath in the bond market. But it will definitely store up inflation trouble down the road. Assuming that this is what is going to happen, I do not see capital flows to India being disrupted. If anything, I would think that they would accelerate and not just in the portfolio flows, but also in the direct investment flow.
This is, of course, under the assumption that central bankers are able to put a cap on the bond yields and bring it down in the short run. The problems of not having adequate capital flows and if anything, capital flight, etc, is a story for much later in this decade, not right now.
We have seen a decade of high liquidity and low interest rates but inflation has not made a comeback even after the GFC crisis. The amount of liquidity which has been printed is simply unprecedented but that has not led to formidable inflation coming back at a global level. So do you think directionally inflation is not going to come back?
In the global economy and especially advanced economies, a sustained pickup in inflation is possible only when labour bargaining power returns and that is unlikely at this point in time. It requires a sustained political will and ability to stare down the capitalists who are also part of the Democratic Party in the United States right now. The fear of technology is going to hold labour bargaining power back and the pandemic had impacted women’s employment in the developed world badly. Many have been left jobless. Also many had to go back to their homes because children were not able to go to schools. The number of women rendered jobless is between three and six million. The pool of available labour supply has expanded rather than shrunk post Covid. And therefore a sustained pickup in wages is unlikely and that is indeed the most important precondition in my view, apart from commodity prices for sustained inflation acceleration. That is why I think it is elusive and is probably a story for the second half of the decade and not right now.
At what point will the Reserve Bank of India start to worry about inflation?
The currency, the bond market and the inflation rate to some extent are all intertwined and there are no right or wrong answers. Much will depend on the evolution of global commodity prices. Especially for India, the oil price is important and the central bank can only focus on what it can control at the moment.
I do not think the inflation framework is going to undergo a big change. It will still remain 4 plus or minus 2. As long as the overall trend towards commodity prices remains buoyant, that will continue because the central bankers will somehow find a way to keep the liquidity flow going and manage multiple balls juggling — one to keep the bond yields and commodity prices low and at the same time, global reflation story is continuing and even developed world central bankers are trying to manage impossible set of objectives. The same goes for RBI as well.
So should India start to worry about inflation? I really do not think that is going to be the case until well into the second half of the next financial year and and even then we have the leeway all the way up to 6% and I think we will stay within that band.
It is very important to focus on the real drivers of inflation in India and it is not so much monetary policy, it is really the fact that our regulation — I call it the LIC (licensing, inspection and compliance). We should divest from this LIC and therein comes India’s inflation problem. We have major constraints on production. So India’s inflation is a regulatory phenomenon and not a monetary phenomenon. The central bank is relatively powerless. And therefore the RBI, by and large, until the second half of the next financial year will not have to worry much about the inflation outlook going above that band.