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.
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.