The Cycle Turns, Finally

In a paper entitled ‘The Federal Reserve – Our Problem,’ published last August, we argued that it was likely that the jump in US inflation to 5.5% was not a temporary blip, as many had then suggested, and the Fed would be forced to bring forward a tapering in its bond purchases. This would be followed by the arduous task of raising interest rates. Now investors are coming to terms with the end of an extended period of cheap money. Financial markets are in shudders. Analysts expect at least four interest rate hikes this year with inflation touching 7%.

The consequences of a tighter monetary policy have begun to puncture equities both in advanced economies and emerging markets. In a matter of a few weeks, the Bombay Stock Exchange’s sensitive share index fell from 61,300 points on the 17th January to 58,600 on Friday the 4th February 2022 a drop of 4.5%. It seems likely that this is a forerunner of further pain, as markets globally adjust to a new reality. Accounting for the Fed’s expected hikes over the coming quarters, long term interest rates have surged in America, causing a collapse in asset values. Monetary authorities in emerging markets will have to tighten policies if only to protect their currencies and ward off inflation expectations. In India, as in several other Asian economies, central banks have to walk a tight rope balancing the needs of economic recovery, coupled with the desires of elected governments to spend their way out of sluggishness and the persistent worry that inflation will jump beyond control. The fact is central banks have been flying high on bloated balance sheets and now face a narrow landing strip, where an error of judgement could be consequential.

It is true that the actions of the Fed are frequently more impactful on emerging market economies than those of their own central banks. With higher interest rates in America and an economic slowdown in China, global demand is bound to take a hammering, affecting the output of most countries. But this does come with a happy flip side. Supply chain disruptions coupled with surging shipping freights will begin to moderate in the quarters ahead. Nevertheless, the downside risks include falling demand and price instability which together have the ability to derail economic recovery. In the expectation of higher returns in America, assets like crypto-currencies and gold will lose some sheen. Moreover, as investors withdraw from emerging market financial assets, bonds and equities will consequently adjust to the new regime. Venture funding may be affected for all but the most discerning start-ups that have a real revenue model and perhaps positive cash flows that inspire confidence. Previously, with negligible returns in fixed income securities across advanced economies, investors were prepared to take risky punts in the hope of better scores.

It is, frankly, hard to see how things will eventually turn out. The fact is the world has lived with cheap money for over a decade. On the one hand, the prophecy of doomsayers who have been predicting a harsh punishment as the interest rate cycle begins to turn, may finally come true. On the other, perhaps the impact may be temporary, marginal or both. The reality, as such things normally go, will fall somewhere in the middle. Stronger economies with balanced budgets and low current account deficits will emerge unscathed. Weaker ones may take a harder knock and take longer to recover. But what is certain is that the status-quo will change as the world begins to adjust to a new economic order affecting both the financial sector and the rest of the manufacturing economy. The Fed is really the world’s problem.