FOMC,longtermthinkingandPeterZeihan

Today the FOMC policy decision will be out. Fed Chief will read out the collective decision regarding the trajectory of the interest rate and bond buying in the coming days. Markets expect that no changes will be on offer though the commentary would take a more optimistic tone. In typical CB fashion however the optimism will be complemented with a warning regarding the uncertainty. The minutes for this meeting will be released around the 19^th of May where we will get to know how each participant individually assessed the economy and what are the factors which they considered important. One would do well to read the minutes of the previous policy (March 21) to take a peek in their current thinking.

Our readers can complain that we give US rates, Fed policies and news regarding Dollar maximum coverage in our notes. Sometimes even the local news gets overshadowed by the news in the US. We would say that this is not an oversight but a deliberate attempt to see things in a proper perspective. The US economy and its currency (at least currently) form the base of the global economy. The size of the US treasuries market is close to 21 tn US Dollars, that remains to be the most liquid asset class imaginable and the interest rates prevalent there define the borrowing costs globally. Any country’s monetary policy hence doesn’t work in isolation but in a lock step with US policy. If you raise rates to control inflation locally but the US rates are still low, then there will be large inflows into your economy to take advantage of the carry available. The large inflow would result in the currency appreciation which would make the exports uncompetitive. To stem the rapid appreciation then the CB would buy the US dollars, consequently increasing its reserves and increasing the local currency liquidity. The rise in liquidity then would stoke up inflation as more money would be floating around chasing the same level of output. Then the CB would do OMOs to clear that excess liquidity. The point is that any action done in isolation by any central bank would give rise to second order effects in case it is not in step with the US.

Now a natural question to ask is why the US? Though we have explained it multiple times in past, it is worth repeating one time more on the day of FOMC policy. The answer however lies not completely in the domain of markets and economics. It is more geo-political in nature and more due to how the history has evolved over the last 100 years. Readers are justified to squirm over the mention of a century timeline when the market trades in nanoseconds, but it is the perspective which is important here. Apart from history it also gives us an understanding whether the current edifice of US centrality is viable in future too. Peter Zeihan in his book The Disunited Nations approaches the same query with a geopolitical lens in detail. He deftly writes about the shortcomings of the forecasts which say that country A or currency B are going to take over from the US in the next X years. As per Zeihan the unipolar nature of the world is going to stay for some time (read decades) to come. He delectably analyses the history, geography and demography of each contender to arrive at his view. So, once we make peace with this assertion (one can have its own) we can see the implication. We know that the US Fed is going to keep the rates low. This will be till the inflation shoots up beyond 2%. Raising rates is a politically difficult move also, it impacts the price of other asset classes and impacts the wealth effect. So, the whole world in a sense remains in a low rate scenario. There will be moves to hike rates like the Bank of Canada or Russian Central Bank recently, but the overall equilibrium level has been lowered. Now this will have impact on the expectation on return on other asset classes. Money will start chasing the yields and increasingly enter into riskier zones. Frontier Markets (Ruchir Sharma’s term for very risky countries) will be the new emerging markets. Overall volatility will increase.

The readers can very well say that we could have concluded this in the first line rather than going into a page long spiel. But again, perspective is important. And long-term perspective is important in the long term. Happy FOMC, we will read the minutes of the last policy in the meantime!