Bond auction devolvement, yields movement and Milton Friedman

For the last few weeks as we waited for Mr Powell to announce the shift in the Fed’s monetary policy, and we covered the topic of inflation extensively as to how it is the primary bugbear for any central banker. In the ensuing discussions it came out that economic theories unlike physics are neither universally correct nor uniformly applicable. Economic policies in turn are more akin to traditional medicine which has a bespoke prescription for every patient.

One famous statement which has failed to pass the universality muster has been the one by famous economist Milton Friedman who said that “inflation is always and everywhere a monetary phenomenon”. Going on what the Fed said last week, it becomes imperative that we analyse Friedman’s statement with a much more critical lens. What Friedman meant by employing monetary policy tools to rake up inflation was to jack up the money supply above the absorptive capacity of the economy and as per him inflation would follow.

At least in the developed economies this hasn’t been the case, the prime examples being US and Japan. Both countries have witnessed persistent low inflation, Japan for last 3 decades and the Fed for the last 12 years post the GFC. This is even after massive money printing through QE. It essentially means that there is something more structural going on here (more on that later). In the case of the US, the core PCE (Personal Consumption Expenditure) has been above 2% for two very brief periods in the last 12 years. Even when the economy was close to full employment it didn’t budge up.

Employment logic goes like this: when any economy is close to full employment, the employee bargaining power increases and the wages rise quickly. The rise in wages has a direct correlation with consumer spending and demand, taking the prices up. Even before the pandemic, the US was experiencing a very healthy job market but wage growth was muted. Now with the pandemic inducing jobless rates close to 10%, there is enough slack in the market which needs to be cleared before wage increases can be seen. (NFP is due this week on Friday).

On the other hand, in emerging markets like India, the inflation can come from any direction. It can be supply side (supply disruption, bad monsoon, floods) or demand side (easy liquidity) hence the central bankers have to tread a very cautious line. We will continue this discussion in our future notes.

If we talk about the important domestic news events from last week, two events from the Indian bond markets will be important to recount. We had witnessed that bond yields have been going right which led the RBI to announce OT. In the first OT auction we witnessed that the RBI was willing to purchase long term papers at a lower than market yield indicating the market is at its comfort level. In a similar vein, during the G Sec auctions on Friday the GS 5.77 2030 entire 18000 Cr INR got devolved as the market quoted high yields for the government paper. Again the act of devolvement sends a strong signal to the bond market that the central bank is not happy with the rightward shift.

On the rupee side, after making the currency play in a range of 74.50 -75.00, the sudden absence of USD buying interest has led to sharp appreciation in the rupee. The foreign flows have been robust all along. The month of August saw robust inflows on the FPI side. As per the WSS, the week ending 21^st August saw the Fx reserves inching up 2.3 bn USD to close the week at 537.5 bn USD.