Can you ignore Rajan’s call?

Vatsal Srivastava looks into Indian Reserve Bank Governor Raghuram Rajan’s call for coordinated global monetary policy a distant dream . Rajan earlier predicted the meltdown in the US banking sector which triggered the global recession 

Raghuram Rajan RBI governor Raghuram Rajan has been constantly urging major central banks, particularly the US Federal Reserve, to keep in mind the spillover effects of their ultra loose monetary policies on emerging economies such as India.

This column agrees that in a highly integrated global economy, the zero interest rate policy (ZIRP) era and Quantitative Easing (QE) measures undertaken my major central banks has affected India to a great extent. For example, apart from geopolitical tensions, QE has been a major factor which has held crude prices so high after the financial crisis. Thus, to some extent, importing higher energy costs can be attributed to India’s inflation woes in recent years.

Governor Rajan’s desire that emerging economies have a larger say in setting the global monetary policy agenda is an idea whose time has not come. The reason is simply that the US Federal Reserve does not have a preset path to normalising it’s monetary policy over the medium term. Although, the Fed has been reducing it’s monthly purchases of bonds and mortgage backed securities (MBS) by $10 billion each month, there is still a lot of speculation amongst market participants as to when the first rate hike would occur. Remember what the general consensus at the beginning of 2014 for US bond yields was? The prevailing view was that US ten year yields would be heading north of three percent at least. However, US bonds have not sold off as expected and ten year yields are stuck at below 2.4 percent.

It is true that the crisis in Ukraine and the geopolitical tensions in the Middle East have led to the flow of funds into US bonds and the greenback (both perceived as safe haven assets) in recent weeks. But what has really been at play is arguably the most dovish US Federal Reserve establishment. At each press conference and in the minutes of the Federal Open Market Committee (FOMC), Janet Yellen has categorically reiterated the fact that the US Fed would continue to remain accommodative until a sustainable recovery in the labour market is not seen. Note that nobody is talking about the “Evan’s rule” now – which linked certain threshold levels that key macro variables (inflation and unemployment rate) must reach and US monetary tightening. What US policy makers fail to understand is that the weakness in the jobs market is more to do with structural rather than cyclical problems. One only has to look at a long-term chart of the labour participation rate in the United States and arrive at this conclusion. This column fears that it may be the case that the QE exit strategy may not be as smooth as the Fed desires and we may witness a 1994-style bond crash with US yields rising rapidly by the end of 2014 or early 2015. Thus, we can forget about US policy makers keeping emerging economies in mind while we move from the QE taper to the first interest rate hike. They first need to get their own house in order.

Further, the monetary policies being followed by the main central banks are also divergent. While the US Fed and the Bank of England have rate hikes on their radar, the Bank of Japan and the European Central Banks are haunted by the twin problems of low growth and deflation. Italy is back in recession, German growth has slowed considerably with bonds offering just close to one percent returns and Japan has witnessed the greatest GDP contraction since the tsunami on the back of the sales tax hike. Both the ECB and the BoJ are likely to be ultra accommodative for the foreseeable future.

Mr. Rajan, who correctly predicted the financial crisis, must not expect the developed central banks to keep India’s interests in mind. He must take necessary steps which would insulate India from a global risk off environment if the US QE exit strategy falters. As the US dollar strengthens – which it inevitably would in a risk off scenario, the Indian rupee cannot be seen as a “fragile five” EM currency. Unlike the summer of 2013, when we saw massive outflow of money from EM to DM due to Ben Bernanke’s taper scare, our import cover and FX reserves are in a better position. Our current account is also in a better position largely thanks to the gold import restrictions. Lastly and more importantly, there is a more positive and overweight view on India thanks to the historic Narendra Modi led BJP win as compared to August, 2013.

Most central banks are formulating their monetary policies by using “macro prudential” tools. There is no empirical evidence that this would work. Mr. Rajan cannot turn to such institutions in hope for any coordination at this point of time. He must build India’s own firewall against the negative spillover effects of the ultra loose monetary policies followed by the major central banks.