On 10th June, US inflation was at 8.6% for May, which is a new 40-year high, causing markets in the US as well as India to crash. On 15th June, the US Federal Reserve (Fed) hiked interest by as much as 75 basis points (bps) at one go, but the hike did not generate the required confidence that inflation in the country would be easily tamed. The stock market continued to decline. Investors are, perhaps finally, beginning to realise that this turbulent phase may be quite prolonged.
The Fed appears to think that inflation is getting persistent when it said, “The committee is moving rates up expeditiously to more normal levels, and we came to the view that we’d like to do a little more front-end loading on that.”
It appears that there will be a series of hikes and fairly large ones at that. The fact is, the federal funds rate, even after this hike, remains at 1.6% when inflation is 8.6%. What does it mean for us? Whether rising interest rates will curb US inflation, especially caused by the supply shock, is not clear. But there is a strong inverse correlation between rising rates and emerging markets.
With that as the backdrop, the consensus is this: inflation will remain high; the Fed will keep hiking interest; and emerging markets will remain under pressure. And, yet, we simply do not know enough even today.
How much of the inflation was due to 0% rates, US$5trn (trillion) in bond purchases, and US$7trn in national debt—all caused by the Fed and successive US governments?
To deal with the shock of the pandemic, the US made stimulus payments of up to US$1,200 directly to every citizen; small businesses could borrow money at very low rates, and unemployed citizens were paid US$600 per week.
If that is being unwound, what will be its impact on demand?
How much of the inflation is due to China’s lock-down and the Russian war with Ukraine, which has disrupted supply chains and led to high energy and food prices?
No one has exact answers, not even the central banks. And, yet, there has emerged a widespread consensus about rising inflation and rising interest rates leading to falling markets. Remember, markets have a way of disappointing strong consensus.
The Forecasting Business
We repeatedly fail to make correct forecasts about complex macroeconomic events and never seem to learn from experience. Two years ago, when a pandemic hit the world, there was a consensus about economic doom. With the movement of people and goods across the country completely shut down, it was expected that output would shrink, unemployment would be sky high and a recession would be inevitable. That was the popular consensus and it was hopelessly wrong.
By the way, do you hear people talking about BRICS anymore? In 2003, Brazil, Russia, India, China and South Africa (BRICS) were touted as the new economic superpowers. Only China lived up to its promise.
In 2007, the world was gripped by the 'Peak Oil' theory and perpetually rising oil prices. It turned out to be false. Oil simply rises and falls on demand and supply, like any other commodity.
In 2009-10, a double-dip recession was considered inevitable after the global financial crisis of 2008. It did not happen.
When the US Fed kept interest rates low for a prolonged period after the 2008 crash, Ray Dalio, founder of the world’s largest hedge fund, feared hyperinflation and his team was reading up about the German economy and markets in the post-World War I period when that country suffered hyperinflation.
In 2011, Portugal, Ireland, Italy, Greece and Spain (PIIGS countries) all seemed headed for insolvency. It did not happen. We do not know whether the current consensus about inflation will also be wrong; but the more widespread the consensus, the more likely it is to fail.
Meanwhile, macroeconomic conditions will continue to unfold in our lives with a lot of twists and turns.
Last week, oil and natural gas prices fell sharply, which ought to boost sentiment this week. As we navigate choppy waters, there will be several such periods of relief when the tide would seem to turn for the better. If the central bank fears a sharp demand slowdown, it may pause its rate hikes which would fire up stock prices again.
Finally, stock markets often presage actual improvement in economic conditions, while the reported economic data invariably captures the past. It may be worthwhile to pay attention to what the market is telling us, as it did during the pandemic, rather than rely on consensus forecasts.