For years, the Fed has kept interest rates close to zero. This is utterly unnatural. It has been justified as a temporary expedient to ensure a full-fledged US recovery from the 2008 crash. But the US today is growing at a rapid 3.7%. Its job openings have shot up to 5.75 million, while unemployment is down to 5.1%. The US now has only 1.4 unemployed people for every job opening, against the peak of 6.8 in 2009. Inflation remains low, thanks to falling commodity prices, but the job market is tightening. This provides a clear case for ending zero interest rates, and returning, in stages, to a more normal 2%.
Zero US rates have prompted trillions of dollars to flow into emerging markets, seeking higher yields. This has inflated stock markets and currencies in emerging markets to unwarranted highs. A rise in US interest rates will send some of these trillions back to the US. This will inconvenience emerging markets used to easy dollar inflows. Expectations of a Fed hike have caused huge turbulence recently, with currencies and stock markets see-sawing and plunging. China has suffered a stock market crash, and has spent $ 94 billion to prop up its currency and stem a massive capital outflow.
Emerging markets must accept that the dollar bonanza was always unsustainable. A downward adjustment will be an inevitable return to normalcy, not disaster. Countries that have failed to prepare for the inevitable will suffer, but the US cannot provide a dollar bonanza forever.
In mid-2013, when the Fed first thought of ending bond purchases (a first step before raising interest rates) almost a trillion dollars flooded out of emerging markets. India was among the worst hit. Paralysis in decision-making by the UPA government had almost halved GDP growth to 4.5%, the current account deficit had skyrocketed to 4.9% of GDP, and inflation was in double digits. The Sensex crashed, and the exchange rate went from Rs 55 to the dollar to a peak of Rs 68. Raghuram Rajan took over as RBI governor at that juncture, created a clever device to bring back dollars through the NRI window and clamped down on gold imports. Within months, normalcy returned to emerging markets, including India.
Rajan complained at the time that the US should have prepared markets better for the coming taper and rate increase. That would have ensured a more orderly outflow of dollars, avoiding blind panic. However, since then all markets have had two years to prepare for higher US rates. None can claim to be caught unawares.
Even if the Fed postpones its rate increase by one quarter or two, that really cannot make much difference. Countries that have failed for two years to prepare for a dollar outflow are not suddenly going to solve the problem with a short postponement. They face deep structural problems arising from China’s slowdown and the consequent collapse of the demand for and price of commodities, on whose export many emerging markets depend. Much painful restructuring is inescapable, regardless of what happens to US interest rates.
Some economists suggest that zero interest rates for some more time will serve US interests. Core inflation is just 1.2%, wages have not taken off, and commodity prices are falling. What’s the hurry? Why not keep interest rates low to enable OECD governments to build long-term infrastructure cheaply? Answer: experience suggests that low rates will more likely create asset bubbles than an infrastructure boom.
Wall Street experts like Mohammed El-Erian say the share of emerging markets in world GDP has doubled to 50%. They are already down, and may get knocked out by higher US interest rates, causing a global recession that hits the US too.
On the other hand, US experts like Richard Fisher say that whenever the Fed has waited for full employment before raising rates, it has pushed the US into recession. So, the time to raise rates is now.
Central bankers from Mexico, Peru and Indonesia have traced market turbulence to uncertainty over the Fed’s rate. They think the turbulence will pass once the Fed actually announces a schedule for raising rates. They see this as desirable, not disastrous.
Financial squalls will occur, but will pass, as in mid-2013. India has plentiful forex reserves, a very modest current account deficit, and falling inflation and fiscal deficit. It is well positioned to adjust to the slowdown in China and the end of the dollar bonanza. Ultimately, economic progress in India will depend on developing top-class institutions and policies, not on hoping for favourable global conditions forever.
