Janet Yellen comments, inflation illusion and RBI Governor's speech

Dow Jones closed with a mild gain yesterday. The gain however masks the turbulence which the equity indices witnessed during the day. The Treasury Secretary Janet Yellen earlier in the day in her pre-recorded interview commented that “maybe the interest rates will have to rise somewhat to make sure that the economy doesn’t overheat.” The equity markets plunged post the comments. However later in the day she retracted saying that “It’s not something I am predicting or recommending. If anyone appreciates the independence of Federal Reserve, I think that person is me.” The volte face soothed the frayed nerves.

Now for all this time whenever we analyse the current low interest rate and ample liquidity regimes across the world, we have added the qualifier that all this is inflationary as per the textbook economics. However, economics not being a hard science, surprises its practitioners on a regular basis. Inflation in the developed world has been the case in point. A lot of commentary was written in the past decade post multiple QE rounds that how this will give rise to a bout of high inflation. But that didn’t happen. Policy makers are aware of the same and account for it in their actions. All the Biden infrastructure plans and lavish spend on jobless benefits have a genesis in the belief that inflation will remain benign. As per the Fed speak even if it raises its head it can be termed as “transient” and will be allowed to run above the average (2%) for times to come. Readers would appreciate that low borrowing costs though is good for the private sector, but it benefits the government of the day much more. It can announce ambitious spending programs with a lower interest outgo. Till the time inflation remains under control the public which depends on “fixed income” that also remains satisfied. It is a politically sound strategy compared to tighten your belt “austerity” rhetoric.

A small detour here the income from bonds is called “fixed income” because the cash flows remain fixed over the period of the bond pay out. But the “fixed” component is highly illusory, it is only fixed in nominal terms not in real terms. In real terms the prices of the commodity which you are going to buy can increase bringing down your purchasing power. Your consumption which is needed for survival is an inelastic quantity.  Long argument short, the reason for low inflation amidst plentiful liquidity and low rates is still an unexplained phenomenon. Modern economists tie it to the productivity gains and globalisation of the world, but a very sound theoretical model is still to evolve. Productivity gains allow a product which is 2X superior to be made in half the price and globalisation ensure that the products get made in the cheapest location possible in the world and then gets shipped to any corner. But readers should mind the fact that these are explanations. Economists can come up with an equally convincing explanation if the inflation changes its course. Hence Yellen comments should be read keenly even if she has retracted the same. In the other countries including India one would do well to understand that their rate cycle will turn (or must turn) much before the US.

Domestically the most important news is an unscheduled address by RBI Governor at 10:00 am local time. Given that the second wave of the pandemic has hit India really hard, markets would look keenly towards the central bank on what kind of succour which it can offer. The 10-year benchmark bond ended the day at 6.01 yesterday. Off late as the OIS rates are dropping across the curve, the market is gearing up for a prolong pause on the rate hike front. Maybe some more clarity will emerge post the governor’s address today.