By now, it is passé to warn that the US Federal Reserve is “behind the curve” in fighting inflation. In fact, the Fed is so far behind that it can’t even see the curve and may have to slam on the policy brakes to regain control before it is too late.
The US Federal Reserve has turned on a dime, an uncharacteristic about-face for an institution long noted for slow and deliberate shifts in monetary policy. While the Fed’s recent messaging (it hasn’t really done anything yet) is not as creative as I had hoped, at least it has recognized that it has a serious problem.
That problem, of course, is inflation. Like the Fed I worked at in the early 1970s under Arthur Burns, today’s policymakers once again misdiagnosed the initial outbreak. The current upsurge in inflation is not transitory or to be dismissed as an outgrowth of idiosyncratic COVID-19-related developments. It is widespread, persistent, and reinforced by wage pressures stemming from an unprecedentedly sharp tightening of the US labor market. Under these circumstances, the Fed’s continued refusal to change course would have been an epic policy blunder.
But recognizing the problem is only the first step toward solving it. And solving it will not be easy.
Consider the math: The inflation rate as measured by the Consumer Price Index reached 7% in December 2021. With the nominal federal funds rate effectively at zero, that translates into a real funds rate (the preferred metric for assessing the efficacy of monetary policy) of -7%.
That is a record low.
Only twice before in modern history, in early 1975 and again in mid-1980, did the Fed allow the real funds rate to plunge to -5%. Those two instances bookended the Great Inflation, when, over a five-year-plus period, the CPI rose at an 8.6% average annual rate.
Of course, no one thinks we are facing a sequel. I have been worried about inflation for longer than most, but even I don’t entertain that possibility. Most forecasters expect inflation to moderate over the course of this year. As supply-chain bottlenecks ease and markets become more balanced, that is a reasonable presumption.
But only to a point. The forward-looking Fed still faces a critical tactical question: What federal funds rate should it target to address the most likely inflation rate 12-18 months from now?
No one has a clue, including the Fed and the financial markets. But one thing is certain: With a -7% real federal funds rate putting the Fed in a deep hole, even a swift deceleration in inflation does not rule out an aggressive monetary tightening to re-position the real funds rate such that it is well-aligned with the Fed’s price-stability mandate.
To figure this out, the Fed must hazard an estimate of when the inflation rate will peak and head lower. It is always tough to guess the date – and even harder to figure out what “lower” really means. But the US economy is still running hot, and the labor market, at least as measured by the plunging unemployment rate, is tighter than at any point since January 1970 (on, gulp, the brink of the Great Inflation). Under these circumstances, I would argue that a responsible policymaker would want to err on the side of caution and not bet on a quick, miraculous roundtrip of inflation back to its sub-2% pre-COVID-19 trend.
Again, consider the math: Let’s say the Fed’s projected policy path, as conveyed through its latest “dot plot,” is correct and the central bank takes the nominal federal funds rate from zero to around 1% by the end of 2022. Couple that with a judicious assessment of the disinflation trajectory – not too slow, not too fast – that foresees year-end CPI inflation moving back into the 3-4% zone. That would still leave the real federal funds rate in negative territory at -2% to -3% at the end of this year.
That’s the catch in all this. In the current easing cycle, the Fed first pushed the real federal funds rate below zero in November 2019. That means a likely -2% to -3% rate in December 2022 would mark a 38-month period of extraordinary monetary accommodation, during which the real federal funds rate averaged -3.1%.
Historical perspective is important here. There have been three earlier periods of extraordinary monetary accommodation worth noting: In the aftermath of the dot-com bubble a generation ago, the Fed under Alan Greenspan ran a negative real funds rate averaging -1.1% for 31 consecutive months. Following the 2008 global financial crisis, Ben Bernanke and Janet Yellen teamed up to sustain a -1.9% average real funds rate for a whopping 62 months. And then, as post-crisis sluggishness persisted, Yellen partnered with Jerome Powell for 37 straight months to hold the real funds rate at -0.9%.Make your inbox smarter.SELECT NEWSLETTERS
Today’s Fed is playing with fire. The -3.1% real federal funds rate of the current über-accommodation is more than double the -1.4% average of those three earlier periods. And yet today’s inflation problem is far more serious, with CPI increases likely to average 5% from March 2021 through December 2022, compared with the 2.1% average that prevailed under the earlier regimes of negative real funds rates.
All this underscores what could well be the riskiest policy bet the Fed has ever made. It has injected record stimulus into the economy during a period when inflation is running at well over twice the pace it did during its three previous experiments with negative real funds rates. I deliberately left out a fourth comparison: the -1.7% real federal funds rate under Burns in the early 1970s. We know how that ended. And I also left out any mention of the Fed’s equally aggressive balance-sheet expansion.
By now, it is passé to warn that the Fed is “behind the curve.” In fact, the Fed is so far behind that it can’t even see the curve. Its dot plots, not only for this year but also for 2023 and 2024, don’t do justice to the extent of monetary tightening that most likely will be required as the Fed scrambles to bring inflation back under control. In the meantime, financial markets are in for a very rude awakening.
New PM and reforms Agenda
Pakistan needs all-out fundamental structural reforms in all areas of governance. However, the most important and immediate is political stability — the main challenge faced by the 23rd Prime Minister of Pakistan, Mian Muhammad Shehbaz Sharif.
Before taking the oath, after elected with 174 votes of members of the National Assembly, he made a number of pledges, reported amongst others by Associated Press of Pakistan. These measures were more in the nature of fire-fighting than fundamental structural reforms. In this article, an attempt is made to highlight some key areas requiring immediate attention.
The best way to bring about transparency in public finance and uproot financial crimes is establishment of a central anti-crime agency as highlighted in Uprooting corruption: Lessons from China, Global Village Space, May 12, 2021. Political parties must get rid of tax evaders and those living beyond means in their ranks and files.
Parties should also get rid of cultism—one man controlling the entire party. Once elected as the Prime Minister he/she should not head the party. So far no political party is adhering to the basic norm of democracy that is separation of party control and running state affairs. The party should make the government accountable.
In utter violation of the Constitution, no party is holding elections as elsewhere in the world where bona fide democracy exists. This is the main area where we need to focus before talking of economic revival. Authoritarianism is apparent in our political culture.
No one should be indispensible. Individuals come and go—what matters is welfare of masses, effective functioning of institutions and enforcement of rule of law. Democratisation of political parties, accountability of all and supremacy of the Constitution alone can strengthen democracy—this is also necessary to check external institutional influence and control of party by those having money power.
It is time to reform all institutions and ensure economic progress of Pakistan for which a detailed roadmap is given in Friend for all seasons, Narratives, May 8, 2021 explaining what we can learn from our most trusted friend China while celebrating 70 years of cherished relations and the importance of China-Pakistan Economic Corridor (CPEC) and Belt and Road Initiative (BRI).
The recent article by Shakeel Ahmad Ramay, Fixing the economy and CPEC, The News, April 11, 2022, gives many pragmatic solutions for fixing the economy as well as CPEC and the following paragraph is worth quoting:
“In the conclusion, ruling elite, new government and parties will have to work on four areas, which is pre-requisite to make the CPEC cooperation a success. First, the ruling elite will have to put the house in order and political elite will have to come of out mentality of self-greatness. Second, government will have to devise SEZs policy and cooperate agriculture policy immediately.
Third, there should be no political games or point scoring to present itself champion of China-Pakistan brotherhood. As China does not care about parties or individuals, China only cares about State of Pakistan and People of Pakistan. Especially PMLN and PPPP will have to learn this and they must avoid self-projection on this front”.
The salient points for consideration of all political parties and national debate to evolve National Reforms Agenda, beyond party affiliations, before next elections can be:
- Creating new province — South Punjab Province — for which constitutional amendment bill is already lying in National Assembly, filed on March 24, 2022.
- Making Karachi federal territory to ensure that it gets due funds and best administration.
- Carrying out fundamental reforms in the justice system and in administrative/governance apparatuses to eliminate the causes of litigation. Ensuring efficacy and accountability of all institutions.
- Revamping of education system to end ignorance and illiteracy, and make people skilful rather than distributing paper degrees and diplomas. Focal point of education should be creating a society that is tolerant, disciplined, courteous and knowledgeable — capable of making innovations and technological advances.
- Holding direct elections of Senate and giving it powers to vote on Money Bill.
- Decentralising political, administrative and financial responsibility to local governments. Education, health, housing, local policing, and all civil amenities should be provided through elected representatives of the local governments that should have powers to raise taxes for these purposes.
- Digitizing, enforcing transparency and accountability in the governments at all levels to enable citizens to understand and participating fully in the process of national integration.
- Reforming civil services, ensuring fair deal for employees with effective and across the board accountability.
- Eliminating terrorism, sectarianism, bigotry, intolerance and violence through enforcement of law and by taking concrete measures to ensure social development of society based on higher values of life and humanity.
- Implementing strict laws to curb terrorist financing, money laundering, plundering of national wealth, political write off of loans and leakages in revenue collections.
- Devising long-term and short-term strategies to break the shackles of debt-trap, making Pakistan a self-reliant economy and ensuring social security and economic justice for all citizens.
- Reforming and strengthening of management of public finances. Transparent public sector spending coupled with efficient performance.
- Controlling wasteful, non-developmental expenditure.
- Reforming of technical, institutional and organizational dimensions of public finance.
- Ensuring good governance and corruption free administrative and judicial structures.
- Federal government should only collect income tax and customs duty. Harmonised sales tax on goods and services should be in the provincial domain. All federal, provincial and local taxes should be collected through one agency (National Tax Authority) which should also disburse pensions and other social security payments to all citizens.
- Reducing excessive marginal tax rates making them compatible with other tax jurisdictions of the world, especially in Asia. Substantially reducing corporate rate of tax. Eliminating onerous taxes and other regulations for corporate sector that are main stumbling blocks for domestic and foreign investments. Simplifying tax laws and procedures.
Dr Nadeem Ul Haque, Vice Chancellor of PIDE, in How Pakistan Became an Asian Tiger by 2050 has offered an optimistic, futuristic and realistic perspective for a prosperous Pakistan. Unfortunately, this work has yet not been given the attention it deserves by policymakers, legislators, academicians, businessmen and administrators.
Our politicians, administrators, intelligentsia and entrepreneurs keep on complaining about multiple and complex challenges faced by Pakistan but seldom strive to implement even the available and workable solutions by local experts. We want IMF, World Bank and others to reform us. This is our real tragedy and dilemma.
We must appreciate and implement the indigenous research-based solutions after debate in public and in national and provincial assemblies and Senate. The Standing and Special Committees should invite (through virtual platforms if needed) experts for assisting and there should be live telecast so that public learns the process of legislation for beneficial reforms.
Russia-Ukraine War and Its Impact on the Global Economic System
The conflict between Russia and Ukraine will seriously affect the world economy in many ways. Changes in supply and demand in areas of energy and commodities will undoubtedly exacerbate global inflationary pressures.
The major sanctions on Russia include: removing Russian banks from the Swift messaging system established for international transactions; freezing the assets of Russian companies and oligarchs in western countries; and restricting the Russian central bank from using its $630 billion (£473 billion) of foreign reserves. In response to these moves, Russia has been placed by financial institutions to junk status. In other words, the Russian default is certain.
It is estimated that between the Bank of Russia and the private sector, Russia contributes roughly $1 trillion to liquid global wealth, of which about $300 billion is deployed in money markets. Sanctions have almost disturbed the $1 trillion balance sheet globally, which will contribute to inflation and commodity prices
Following sanctions, the big western companies like Apple, Audi, BMW, Boeing, Coca-Cola, Dell, Ford, Netflix, Nike, Nestle, and Renault have either exited the country or closed their stores and stopped sales. Since Russia is one of the major producers of some important base metals such as titanium, nickel, palladium, and aluminium, their prices are also expected to increase. This increase will affect global industries, especially the automotive industry. There will also be an increase in agricultural products’ prices because of the war. More than a quarter of world wheat is produced by Russia and Ukraine. At the same time, corn, barley, and rapeseed prices will increase.
Geopolitical fracture lines build slowly over time, making it tempting to delay tough strategic realignments. But once those lines fracture, it is often too late to do anything.
European banks, particularly in Austria, France and Italy, are affected badly due to sanctions on Russia. France and Italy’s banks each have outstanding claims of about US$25 billion on Russian debt, while Austrian banks had US$17.5 billion.
Since 2014, financial institutions in the US have been decreasing their interaction with Russian banks. Still, Citigroup has a small portion of $ 10 billion exposure in Russian banks.
Ukraine is also on the verge of default. Ukraine’s $ 60 billion worth of bonds has also gone to junk status.
French banks BNP Paribas and Credit Agricole are the most exposed to Ukraine because of their local subsidiaries in the country. Societe Generale SA (SoCGen) and UniCredit the top EU banks, with the largest operations in Russia, are also among the most exposed to Russian debts. European, US and Japanese banks could face serious losses, potentially to the tune of US$150 billion.
Switzerland, Cyprus and the UK are the biggest destinations for Russian oligarchs seeking to store their cash overseas. Cyprus also attracts Russian wealth with golden passports. Financial institutions in these countries are all likely to lose business because of the sanctions. The share prices of UK banks Lloyds and NatWest are both down more than 10 per cent since the start of the invasion.
Apart from banks, the war is going to lead to substantial losses for many businesses with interests in Russia. Any companies that are owed money by Russian businesses are going to struggle to get repaid, given that the ruble is down 30 per cent and the Swift restrictions are going to make payments very difficult. US companies have about US$15 billion of exposure to Russia. Many of these debts will potentially end up being written off, causing serious losses.
Some oil companies like Shell and BP have decided to offload assets that they own in Russia. Others such as trading and mining group Glencore, which has significant stakes in two Russia-linked companies, Rosneft and En+ Group, are reviewing their investment status. But if the value of these assets evaporates because there are no buyers at sensible prices, companies like these could be looking at substantial write-downs.
this means that international capital is seeking new safe-haven, bringing incremental international capital to China’s domestic capital market, making China’s financial market one of the beneficiaries of the crisis. However, China’s ability to maintain the stability of its surrounding environment remains a major consideration for international capital flows in the face of growing geopolitical competition and conflict.
The economic and financial sanctions imposed by the US and Europe will exacerbate Russia’s recession. Nonetheless, Russia can still utilize its energy resources for its geopolitical interest. Russia is said to have substantially raised natural gas prices. European natural gas prices have soared by 41 per cent. In addition, nearly 35 per cent of palladium, an important element used in the US semiconductor industry, was imported from Russia. Once Russia stops supplying palladium to the United States, the shortage of chips in the US will be exacerbated. At the same time, 90 per cent of neon, another element used in the US semiconductor industry, was imported from Ukraine. A sharp increase in the price of neon as a result of the war could also have some impact on the US semiconductor industry. Some market institutions have analyzed that crude oil prices may once again exceed the USD 140 mark, which will benefit Russia, a major energy exporter, enough to compensate for the losses caused by rising financial settlement costs. Russia has great exposure to the UK, and as the result of the conflict, it is expected that the impact on the UK could be to reduce GDP growth by around 0.8 per cent to 4.0 per cent in 2022 and 0.5 per cent in 2023. The UK draws most of its gas imports from Norway and produces a sizeable chunk of its own gas needs, so interruptions in supply would be less likely, but it would suffer from higher wholesale gas prices.
The Russia-Ukraine conflict has become an economic skirmish as much as it is a geopolitical war.
As geopolitical conflict intensifies, this change will have implications for the long-term evolution of global financial capital markets. Geopolitical fracture lines build slowly over time, making it tempting to delay tough strategic realignments, but once those lines fracture, it is often too late to do anything but react. The Russia-Ukraine war is a warning that how suddenly geopolitical motion can accelerate. Businesses should consider their risk exposures carefully. These recent events should raise the premium for home market strength and increase the discount for far-afield holdings.
Stronger Contractionary Monetary Policy Needed to Achieve ‘Stabilizing Expectations’ for China
The escalation to war in Ukraine and the series of sanctions against Russia by Europe and the United States has acerbated the volatility of the global financial and energy markets. The increased geopolitical risks have also had a serious impact on the global economy. International institutions such as the IMF and the World Bank have issued warnings one after another that China’s economy will face new challenges as energy supply and demand fluctuate and supply chain distortions intensify. This change in the situation has already affected
China’s domestic capital market. Recently, the common stock market (A-shares) has been volatile, reflecting investors’ gloomy outlook on the capital market and China’s economy. According to the theory of behavioral economics, changes in expectations will affect future economic activity.
This is not only an issue of economic confidence but it also affects the behavior of residents and enterprises in the future on economic activities such as consumption and investment, which will have a substantial impact on the micro and macroeconomy. ANBOUND researchers believe that China will need to adjust and respond to macroeconomic policies, especially to promote further easing of monetary policy in taming market concerns and provide substantial support for “steady growth”.
At The Two Sessions this year, the government’s Work Report put forward the goal of achieving economic growth of 5.5% this year, and at the same time emphasized increasing macro-policy to support the economy. According to the current market reaction, some scholars and research institutions believe that the economic growth target of 5.5% has fallen significantly compared to last year’s economic growth rate of 8.1%.
However, due to the chaos brought about by the COVID-19 pandemic, the average growth rate in the past two years was only 5.1%. Therefore, when the impact of the pandemic is removed and the economy returns to “normal”, it is challenging to achieve the economic growth target of 5.5% this year. The further formation of endogenous power is needed and it also requires macro-policy support to stabilize demand.
Some researchers have mentioned that the current target of 5.5% has a positive effect on enhancing market confidence and expectations, but to achieve the economic growth target, the main path is to build infrastructure to support the economy and wait for the real estate market to stabilize.
It is anticipated that the pandemic control measures might be reduced, allowing consumption to rebound. However, the market emphasis point remains primarily dependent on whether the real estate market is improving, and there is little “enthusiasm” about the expansion infrastructure. Under this situation, the “stabilizing expectation” effects of positive fiscal policy are still limited. Judging from the latest CPI and PPI data, the consumer price level continues to be depressing while the production price level has risen.
This represented the fact that the development of China’s domestic consumer demand and investment needs is continually diminished, while the pressure on business expenses from PPI stays constant. Coupled with the recent continuous fluctuations in the A-share market, various situations show that changes in market expectations still reflect the contradictions on the demand side.
This means that China’s overall economic growth will still be a process of “drilling the bottom”. Although fiscal spending will expand this year, in terms of China’s current economic size, its intensity is still in the “steady” category, and the support and coordination of monetary policy are still needed to unleash the effectiveness of the easing policy.
At the same time, ANBOUND also pointed out that the Russia-Ukraine crisis has further worsened the international geopolitical environment and increased the uncertainty of the global economy. Changes in the current economic situation show that the market still has an urgent need for macroeconomic policies, especially monetary policy support. Therefore, researchers at ANBOUND believe that it is still necessary to further ease monetary policy at present to help the economy achieving a “soft landing” as soon as possible by releasing policy space.
Since the fourth quarter last year, monetary policy has turned to ease and has provided substantial support for economic stability through comprehensive reduce moderately the Required Reserve Ratio (RRR) and interest rate.
However, following China’s Spring Festival, the rate of this continual easing decreased and market liquidity was recycled. On the one hand, the market needs to digest the impact of the easing policy and improve the effectiveness of the policy; on the other hand, it is also a signal for the policy to remain stable, to avoid misleading the market causing “waterfall”.
However, in terms of the forward-looking, precise, and sustainable monetary policy, considering the new situation and changes in market expectations, monetary policy needs to be adjusted promptly, seize the time window, and further reduce market interest rates to stabilize short-term market expectations and prevent panic in the capital market that would cause chain reaction.
Judging from the current changes in the capital market, the RMB exchange rate still shows a strong tendency to appreciate despite the intensified international geopolitical risks and the rebound of the U.S. dollar index. This may be the case though the Federal Reserve may end its balance sheet reduction and start raising interest rates in March. Appropriately lowering the interest rate level will not have a significant impact on the RMB exchange rate under the turbulent international situation.
Promoting further easing of the currency will help release the pressure of RMB appreciation and increase the profitability of Chinese export enterprises. Increasing currency liquidity and reducing financing costs are also beneficial to the domestic capital market, helping to stabilize asset prices and improve corporate profitability.
With the stability of China’s economic fundamentals, the stable income of its domestic capital market will remain attractive to international capital. Under such circumstances, the impact of changes in the international policy environment on China is still manageable.
Most crucially, by releasing signals to consolidate the macroeconomy through monetary policy changes, the capital market and economic principals can turn their bearish expectations around. According to China’s existing conditions and stages, this will be the crucial key.
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