Archive for September 8th, 2008

Divergence in Fed and ECB monetary policy -II

September 8, 2008

I had written a post explaining the difference in monetary policy between US and ECB. ECB is more hawkish on inflation compared to Fed; Fed is more bearish on growth, though with the recent ECB monetary policy statement, ECB is pretty bearish as well. As a result, Fed has used both liquidity and interest rates to calm markets but ECB has only used liquidity measures.

I came across this speechby Janet Yellen, President San Francisco Fed. She is quite bearish on the US economy and upbeat about inflation coming down. She says:

monetary policy in Europe has been less accommodative during this period than in the U.S. For example, while the Fed cut its target interest rate substantially to 2 percent during the course of the credit crisis that began last summer, the European Central Bank kept its policy interest rate steady throughout, and then tightened by 25 basis points to 4¼ percent in July.

Part of the reason for the difference is that the European Central Bank’s mandate requires it to focus on controlling headline inflation, which reached 4 percent for the twelve months ending in July—a rate well above its official objective of below, but close to 2 percent.

In addition, even though much of the recent increase in inflation is attributable to commodity prices, and therefore likely to be a temporary phenomenon, the central bank has been worried about second-round effects on inflation expectations, wages, and other costs, and justifiably so.

The euro zone has a greater degree of wage indexation and collective bargaining than the U.S. So it is more likely that higher headline inflation will fairly quickly get built into wages there, setting off a wage-price spiral that could be persistent and difficult to stop.

That is a nice way of explaning the differences in the 2 economies and monetary policy actions. She points there is little chance of it happening in US:

However, that does not mean that we can afford to ignore the risk that such a damaging spiral could develop here.

 Fortunately, I do not see signs of this development at this point. First, the reports of our directors and business contacts are consistent with the view that no such dynamic has taken hold. Outside of a few booming sectors such as energy, we hear no reports of escalating wage pressures even though higher food and energy prices have eroded the real incomes of American workers. Our contacts note that high unemployment is holding down labor turnover, suppressing the need to raise wages more rapidly. The two broad measures of national labor compensation that we monitor have shown remarkably small increases recently

Moreover, various measures of longer-term inflation expectations suggest that they remain relatively well contained. With the recent decline in commodity prices, inflation expectations for the next five years have edged down slightly in both the Michigan Survey of households and the Philadelphia Fed’s Survey of Professional Forecasters. Furthermore, since June, compensation for inflation and inflation risk over the next five years—as measured in markets for Treasury Inflation Protected Securities—has dropped noticeably and is now under 2 percent.

The key is managing expectations. I don’t understand this focus on inflation expectations  over 5 years!! That is too long a time. As I have explained in this paper long term is a sum of short-term. If people realise Fed isn’t anchoring inflation, they will revise their expectations.  Moreover, she expects the inflation to be higher.

Headline inflation is likely to remain much higher than I would like for a quarter or two as previous increases in commodity prices boost the prices paid by consumers for food and energy. With regard to core inflation, I wouldn’t be surprised if it runs modestly higher for a while, too, as businesses pass on some of their higher energy, transportation, and other costs to customers. However, for several reasons, I expect both headline and core inflation to move down to a much more moderate rate of just over 2 percent next year.

So, if inflation continues to be high, inflation expectations would follow as well. You need to have a more immediate approach than a 5 year approach to inflation.  And she also says inflation would ease by next year. Next year when? December?

However, Yellen has been quite right in her view on employment numbers as they have deteriorated further. So there is hope for sure. But again, never underestimate inflation. It has more surprises than you can ever imagine. That is the biggest lesson learnt.

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Dr Subba Rao’s to do list

September 8, 2008

There has been vast amount of newsprint since Dr. D. Subba Rao (DSR) was namedas the new RBI Governor. Well, I must say times are changing as one of the newspapers tells me this is the  first time Finance Minister has announced the name of the new RBI Governor. The importance of Monetary Policy and Central banker is growing in India (and media) just like we see in developed economies.

The media speculation has shifted from who the RBI Governor would be to what Dr. Subba Rao would do.  The focus on Dr DSR started with his profile (see this ET version as well, Mint).

It has now has moved to on what Dr. DSR should be doing – Business Statndard  , Mint , ET, FE. As Dr. DSR has himself indicated the priority now would be on inflation and then financial sector reforms. The talk is on what he should do on both the fronts. It will be interesting to see what he does.

I would say Dr. Reddy has left quite a legacy behind and would be interesting to see how Dr DSR takes up the challenge. Meanwhile, Dr. Reddy has left him with lots of food for thought while leaving.

Dr Reddy’s reality check on Indian economy and policy

September 8, 2008

There is vast amount of coverage on Dr. Reddy’s tenure. (Hindu, ET). However, this last press coverage of Dr. Reddy is a standout for his insight on Indian economy and policy …and yes his humor.

On interest rates: According to Reddy, if he had it, his way monetary policy would have been tighter. He said charges that growth would be hurt because of RBI’s rate hikes have been belied. “While those with balance sheet interest do speak about the negative impact of higher interest rates, the decision has to be looked at analytically.”

I liked his take on those with balance sheet interest. Actually it is a puzzle. Usually, tight monetary policy leads to higher interest rates and lower corporate borrowing and industrial activity. However, in my research paperI have noted this is not really the case. Infact, both interest rates and industrial activity grow together. One of the main reason is that Indian firms rely more on internal resources for capital expansion and not much on debt/equity capital. (Read this Mint analysis as well; scroll down). Infact, this puzzle could also be the reason why credit has continued to expand despite Dr. Reddy hiking rates through out his tenure.

On exchange rates, the former governor made it clear that he is vehemently opposed to allowing the rupee to appreciate, even if a rising rupee adds to inflationary pressures. According to him, the rupee cannot be allowed to appreciate excessively in an economy, which runs a current account deficit, a wide trade deficit and a wide fiscal deficit merely because global capital, for the present, finds India attractive.

This is a challenge RBI has been facing for a long time (my paper on the challenges here). What should it do? Can we allow the rupee to appreciate and let the trade deficit widen? Or should it suppress the appreciation and allow some imported inflation and manage the sterilization? I would suggest problem is with excessive capital flows and there is a need to revisit them.

On making RBI a true monetary policy manager: Mr Reddy let out a secret on how initially, when he took charge as deputy governor, he was favoured the creation of a separate independent entity to manage government debt and how Mr Jalan was opposed to it on the grounds that it was unlikely that the fiscal deficit would improve. Given the Indian context, he said one should not go with an ideological approach, and the next step should be taken only after progress on fiscal consolidation. “The law of the land says that RBI should manage public debt. It was a mandate given to us by Parliament. Change the law. There is no empirical evidence that this function is not being managed efficiently.”  

This is an excellent anecdote from Dr. Reddy. You really can’t have a debt management office with such high fiscal deficit.

Financial markets: Mr Reddy said it is not possible to develop the financial markets without changes in policy and the real sector. According to him, it is not possible to have a market for interest rate futures when you have an inadequate and imperfect spot market, with different level of preparedness between foreign banks, public sector banks and corporates. “You have to consider how much of volatility the public can expect and handle. Foreign banks and private banks may have the capacity to manage it, but others might find it difficult to handle.

Lots of insight. This media hue and cry over absence of various derivative markets in India is simply not needed. We had success in equity derivative markets only when we had a very efficient spot market in equities. Debt and forex both being much more complicated and has taken time to develop. Same is the case with commodities….after much euphoria over the commodities derivatives launch, there was furore that the derivative markets are leading to an increase in prices. The expert committee found the problem is with efficiency of spot markets…I also liked his view on volatility….

On Percy Mistry and Raghuram Rajan reports: According to Mr Reddy, one cannot take a view on issues of such magnitude just because there is an expert committee report. “We are not only looking at Mumbai as a financial centre. Our own stance is a more comprehensive framework. If a table of the decisions were to be prepared with a column on who was required to take action, it would be clear that it was the government which had to act on most of the recommendations.”

This is an excellent comment on expert committees and where the problems lie. Apart from this, check out his humor as well:

The trademark humour was quite evident when he said there was no formal offer of an extension. “ I didn’t have the pleasure of saying no.”

Mr Reddy, who spent over ten years in Mint Street, including five years as governor, said it had been a learning experience. Only to add, “I hope that there was no major cost in educating me .”

Overall a very interesting insight from the man who was closest to all the ongoings. I think we need to have a similar outlook towards central banks policies as we see in growth and institutions literature. After much discussion we have come to the conclusion that no single formula works. Each economy is different and a result central bank would have to tune its policies accordingly. Infact this has been the experience in research as well with central bank operations differing widely.

Assorted Links

September 8, 2008

1. The big news is Fannie and Freddie have been nationalised. WSJ Blog pointsto official statements. It also pointsto email from Freddie outgoing and incoming CEOs

2. The other news is US unemployment has worsened. WSJ Blog points. Krugman also has a good post. Econbrowser as usual has good analysis


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