BlockedCanal,centralbankchiefsandFriedman

Yesterday we had written about the Extremistan event of blocking of the Suez Canal and had surmised that though it is a unique event, the situation might get resolved quickly. But it looks like that it will be few days before the situation can be normalised. And as the trade artery gets blocked the impacts will start becoming visible on market health. As for now there is a 3 Dollar jump in the price of Brent crude which is now trading at 62.5$/bbl. The other markets remain stable, US 10-year yield is at 1.63 and Dollar Index at 92.75. The Euro slips as the continent battles with new infections and new confusion over the vaccine. The Indian Rupee opens stronger with 10-year yields coming down by 2 bps to 6.13. The Market awaits the borrowing calendar and MPC policy (due on Apr 7^th, 2021).

We also saw some important media interactions yesterday by central bank chiefs like Fed Chief interacting with NPR, Fed Vice Chair Richard Clarida speaking to IIF Washington and closer to home the RBI Chief addressing India Economic Conclave. Parsing the text of all these interactions gave the markets some anchor on future monetary policy trajectory. Whereas the RBI chief handled the issue of Financial Sector, Fed’s Clarida outlined his view on the US economy. He said that the unemployment rate in US is close to 10% and not the 6.2% which official estimates show. The NPR engagement of Fed Chief was the most interesting one as the questions were direct, simple and de-jargonised. At one point during the interview the interviewer asked, “Are you scared about the sheer amount of money which Fed has pumped into the economy and whether even the experts think they know what is going on?” The Powell’s answer was direct “You know, we do.” Then he goes on to add that there was a time in the past when the actual quantity of money was very important in determining inflation. That is not the case now and has been such for several decades now.

Readers should take a pause here and try to assimilate the purport of the statement for two minutes. Famous economist Milton Friedman once said that the “inflation is always and everywhere a monetary phenomenon”. What Friedman meant was that as money supply increases, more money chases few goods and price of goods rises. What Powell is effectively saying that the link between the inflation and money supply is broken and Friedman assertion is no longer true.

Let’s take a deeper look into what’s happening here. When Fed creates new money by buying treasuries or other bonds, it pays the bank newly created US Dollars in exchange for these bonds. The bank with this new money has two choices, they can lend it out to public and businesses or can keep it with Fed only, earning a nominal return. By not lending it out they are losing out on the opportunity cost but are enjoying safety in uncertain times. As long as the bank reserves with Fed keep increasing in line with the Fed’s balance sheet, the actual money supply in the economy will be limited. However, Fed’s act of purchasing all these bonds stabilises bond prices and brings the yield on those bonds down. Consequently, creating an environment of lower longer tenor yields. The essential point to understand here remains that though the monetary base has increased the rise in money stock (which includes currency, bank current and saving deposits) has been slow to take off. Till that happens inflation will be controlled. But one question remains, what happens when the banks become confident to on lend? Will Powell be still confident to say, “we do”.