Policy Sedatives: Overwhelming Effects and Unintended Side Effects

Before the Financial Crisis in 2008, it was frequently claimed that the developed economies had permanently ended the cyclicality of prior eras. In fact – a name – the “Great Moderation” – was invented by Economists to describe the stable period from 1984-2008 when the variability of real GDP growth and inflation fell markedly. Recessions did occur during these years, but they represented short and fairly shallow punctuations between extended periods of moderate expansion. In 2004, Bernanke credited “better monetary policy” for the great moderation – meaning, of course, better monetary policy under Volcker, Greenspan and him.

That was before the Great Recession of 2008-09, by far the deepest since the 1930s. The financial crash made the term “Great Moderation” seem hubristic, if not absurd, and for a while it was banished from the lexicon. But now it seems to be back, albeit in a slightly different form.

Post the GFC, global Central Banks have not shied away from adopting a “whatever it takes” policy to support the global economy and avert another crisis. The fact that there is close to US$10tn of negative yielding debt globally bears testimony to this. It also appears that global Central Banks have succeeded in their new mission. After all the US economy is just two months away from surpassing the record 120-month 1991-2001 expansion while US equities have already hit their longest bull run in history.  So have Central Banks finally tasted blood in eliminating the obstreperous business cycle?

While it is difficult to say that business cycles have been eliminated, but it does look like they have been tamed. To put it simply, while unconventional policy response by Central Banks in recent years have avoided recessions, it has led to increased occurrence of mini-cycles. These mini-cycles are shorter in duration but occur more frequently and lead to weaker recoveries.

Below we elaborate some of the characteristics of these mini-cycles:

• The mini-cycles are entirely driven by the performance of the two largest economies in the world – US and China which together account for ~50% of global growth. The US economy is important because of its role as a supplier of dollar liquidity (via its current account) while the Chinese economy is important because of its impact on Asian supply chains
• The mini-cycles comprise shorter periods of boom due to the structural problem of debt and demographics as well as shorter periods of bust (slowdown) since policy-makers have now become very agile in their policy response
• The mini-cycles are a result of the conflict faced by Central Banks in managing short-term growth expectations vs. the longer-term destabilizing forces of excessive leverage
• Although, each mini-cycle elicits a strong policy response by the Central Banks but the subsequent recovery invariably turns out to be weaker than the previous one

Perhaps the best way to explain these mini cycles is to compare the economic environments in late 2015 and late 2018. In late 2015, the global economy was staring at the cusp of recession led by a plunge in oil prices and China induced global manufacturing weakness. As volatility roiled equity markets, policy makers quickly stepped in via the purported “Shanghai Accord”. This was the apparent quid pro quo that emerged from the G20 summit in February 2016 in which the Fed agreed to be patient in raising rates while China launched a major stimulus program. What followed for the next two years were a synchronized global growth recovery and a fierce rally in equity markets.

Fast forward to late 2018 and the environment looks eerily similar to what transpired in late 2015. A curb on leverage at the start of 2018 caused the Chinese economy to slow considerably. As Chinese growth faltered, so did several economies dependent on global trade. With risk assets in a state of turmoil, policy makers once again stepped in with Fed swiftly moving to dampen expectations of further rate hikes and China embarking on policy easing.  In fact, it now appears that these mini-cycles are closely linked to China’s credit cycle with some lag (Chart 1).

   Chart 1: Bloomberg China Credit Impulse (% of GDP)

Source: Bloomberg

While Central Banks through their unconventional policies have managed to depress large variability/volatility in macro data, they have been unable to tackle the issue of prolonged low nominal growth. The remarkable absence of inflation even after unprecedented monetary easing and tight labour markets is particularly startling. Technological advancement is now often used as an explanation for mysteriously low inflation. However, low inflation itself could be responsible for subduing the business cycle due to its dampening effect on incomes. To counter this, the proponents of MMT (Modern Monetary Theory) are now prescribing an unorthodox combination of fiscal expansion supported by Central Bank money printing. Despite criticism from many eminent voices, this new school of thought has been successful in garnering attention, as few within the Fed have now started talking about targeting nominal GDP growth as a policy objective.

However, be it QE or MMT, the fact of the matter is that volatility cannot be suppressed forever. With policy makers now pushed to the wall to either adopt unusual policies or risk deep contraction in asset prices, mean reversion of volatility appears to be the most probable outcome going forward.

In the last few years, like the global economy, the Indian economy has also been experiencing mini-cycles characterized by low growth and low inflation (Chart 2). Apart from global factors, domestic issues like absence of financial slack (declining household savings rate) and health of balance sheet of various stakeholders have led to this subdued environment. While on a relative basis, the Indian economy is the fastest growing economy in the world, the problem is low growth for long (real as well as nominal) coupled with declining investment rate can lead to marked decline in potential growth.

Chart 2: The Indian Economy has been experiencing low growth low inflation in the last 5 years

Source: CMIE Economic Outlook

However, unlike global Central Banks who have tried to fight all headwinds via a “whatever it takes” policy, the RBI seems to have fallen short. While the RBI has been infusing liquidity into the system via OMO’s and forex swaps, the injection has been more reactive rather pro-active (even in the wake of the current NBFC crisis). Their single-minded focus on inflation targeting has meant that the economy has been grappling with oppressively high real interest rates which in turn has been deterring private investments and lowering the economy’s potential output.

Recently, the RBI has expressed its concern over fiscal slippage. In the medium-term, yes that has to be resolved because crowding out is a genuine issue when financial savings are low. However, growth considerations need to take precedence over other things at the point of time. Rather than being dogged down by the fear of inflation (which is non-existent), the RBI needs to err on the side of excessive easing. Moreover, to be more effective, RBI liquidity injection has to be directed towards troubled segments like MSME's, rural economy and NBFC's.

While the ingredients for a sustainable growth cycle may be missing in India, without significant Central bank easing, there is a risk that India’s growth may structurally shift downwards.With India’s medium term growth outlook plagued with uncertainty, the Indian economy/markets in line with the rest of the world cannot escape volatility ahead.