Deviations from Fundamental Economic Principles Will Not Last Long
Economics is a relatively young discipline. Over its short history, it has established certain fundamental tenets based on which appropriate policy decisions can be taken. Evidently, these principles have served the discipline well and proven their worth over time. One such principle is exemplified by the Phillips curve. 
 
Proposed by the British economist AW Phillips, the Phillips curve posits an inverse relationship between unemployment and inflation. Thus, a lower unemployment is synonymous with high inflation and vice versa.
 
 
This relationship seems to have broken down in the US in recent times. The US is currently enjoying a relatively high growth at 3.1% per annum, which has reduced unemployment to 3.6%, the lowest in the last 50 years. 
 
Automation inspired improvement in productivity, the emergence of the gig economy, huge global savings leading to comfortable liquidity and the tax cuts two years back, many reasons have been attributed to the strength of the US economy.
 
According to the Phillips curve, such low unemployment should be accompanied by high inflation and therefore, high nominal interest rates. Surprisingly, the current interest rate in the US for a 10-year bond is just over 2% and the annualised inflation rate is 1.6%! 
 
What is also surprising is that the world over there is a threat of a downturn. Europe is struggling to avoid a recession and China’s gross domestic product (GDP) growth rate has weakened to its lowest level since 1990s.
 
India has seen a drastic reduction in its GDP in the span of less than a year and Japan is forever struggling with the demons of its low growth rate. It would be safe to aver that sluggishness is a distinct feature of the world economy today. Are we witnessing a decoupling of the US economy from the rest of the world? How is a high growth of this magnitude associated with such low inflation? What are the implications for the Indian markets?
 
One of the most important outcomes of the global sluggishness is low inflation and low interest rates. Governments world over have been apprehensive of pump priming investments, fearing a downgrade in rating. 
 
It has therefore become virtually the default responsibility of the central bankers to keep the economy in good shape. Central bankers have not hesitated to reduce interest rates at the slightest hint of a dip in GDP growth rate and have, in fact, committed to do so in future also. 
 
The low inflation and interest rates benefit the US economy in three ways. First, low inflation leads to a significant increase in real wages and a substantial boost to consumption demand. 
 
Second, low inflation and interest rates are beneficial to the stock market, which has been performing exceedingly well for a long time. Finally, business finds it easy to raise funds at attractive rates. Neflix recently issued junk bonds at historically low rate of 5.4%.
 
The US is a huge economy, the largest in the world and like all large economies, its dependence on exports is relatively limited, at 12% of its national income. 
 
Moreover, a large part of the export basket is price inelastic and the demand remains stable despite poor growth in importing countries. 
 
Hence, sluggishness in other economies does not have a significant impact on US exports while the consequent low interest rates prove highly favourable.
 
The prevailing situation is extremely favourable to India, and possibly other emerging markets. While the strong health of the US economy should help exports, the comfortable global funds position should see financial flows continuing in large volumes, something that the Indian economy needs desperately. 
 
The comfortable liquidity position has prevailed for the last decade, with central bankers being liberal in ensuring low interest rates. The inflow of funds not only bridges the gap between savings and investment in India, some of the inflow also seeps into the stock market ensuring continued buoyancy.
 
What about the future? As always, many factors could play party pooper. In the immediate future is the dark shadow of the trade war between the two largest economies, the US and China, that is expected to significantly hit global trade and may lead to weakening of the forces of globalisation. 
 
There is an apprehension that having experienced the longest ever recovery period, a downturn in the US economy is around the corner. A significant factor is the inverted yield curve which has usually been a harbinger of recession. 
 
The standoff between the US and China would definitely hit global trade and impact growth rates. However, I don’t expect it to reduce liquidity; in fact, the opposite should happen. Responding to lower growth, central bankers are likely to pump in further liquidity. 
 
Second, just because the current expansion has been the longest in US history does not imply it will reverse soon. Economic expansions do not commence with a prominently, pre announced end date. 
 
If the conditions aiding growth continue, there is no reason to assume a reversal. Many countries have experienced much longer expansionary periods, including Australia which is in its 28th year of uninterrupted positive increase in its GDP. 
 
As far as the inverted yield curve is concerned, its ability to predict a recession has over the years weakened. Since the 2008 financial crisis, bond pricing no longer reflects economic conditions. Bond prices are now determined more by regulatory action and quantitative easing. 
 
It is expected that any sign of recession will be met with significant quantitative easing by the US Fed. Comfortable liquidity conditions with low interest rates are likely to continue in the foreseeable future, a boon for the Indian markets.
 
A word of caution is warranted. There is invariably a tendency to assume that conditions prevailing at any point in time are likely to continue in future. Even if economic theory points to a fallacy in such a thought process, ‘this time is different’ is an assertion repeated ad infinitum. 
 
We must however remember that deviations from fundamental economic principles do not last forever. Economic principles have a habit of asserting themselves eventually, despite long periods of failure to uphold themselves. 
 
When they do, the impact is always brutal. There is no harm in swimming with the tide, but prudence is advised in being prepared for the reversal when it happens, as it surely must.
 
(Sunil Mahajan, a financial consultant and teacher, has over three decades experience in the corporate sector, consultancy and academics.).
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    COMMENTS

    PRADEEP KUMAR M S

    3 weeks ago

    I have been sitting on cash for the last two years waiting for the fall 😂

    B. Yerram Raju

    3 weeks ago

    Author has brought the text book to the position. Low inflation, Low unemployment and low interest rates are a queer combination. Further, economics built on rational behavior does not any longer hold validity as man invariably behaves irrationally.

    After Fed cut its rates, Down Jones index dropped; stock markets fell all over the world. There is more uncertainty now than ever. No one is able to say whether we are heading towards another major recession although every one is suspicious about it When stimulus is not required it is being extended.
    The case of India is different. We are travelling against the wind.

    Manufacturing is looking downwards amidst a yet-to-settle uncertainty in the financial sector. ECBs are made more attractive. Sovereign Bonds are floated.
    Market sentiment is down. FPIs are slowly exiting. There is benign inflation. Credit markets are yet to find a green herring.

    The fundamentals are on the changing curve. They are still evolving and bending towards behavioral economics. It is not just economists that got NL as much as physicists and psychologists. Interdisciplinary approaches are altering the fundamentals of economics.

    Slowdown woes revealed in India Inc's changing tone and tenor
    Indians are buying less of everything as the economy is losing steam, slowing down for the third consecutive quarter. One indication of this is the changing commentary of managements, which are aimed at pacifying the shareholders at a time of unusual circumstances.
     
    Major fast moving consumer goods (FMCG) companies are suffering the impact of rural distress. Sales growth of even basic products like atta, hair oil and toothpaste have declined.
     
    ITC, while announcing its latest quarterly results said: "The FMCG-Others segment delivered a resilient performance during the quarter amidst a marked slowdown in the FMCG industry across urban and rural markets".
     
    The well known coffee and Maggie maker Nestle India said: "We are proud of our strong performances in Maggi, Kitkat and Munch among others. However, environment continues to be challenging with headwinds in commodity prices and softer demand conditions".
     
    The Cinthol soap, GoodKnight mosquito repellant and Ezee detergent maker, Godrej Consumer Products, said: "Our India business delivered a steady volume growth of 5 per cent, amidst a general slowdown in staples consumption. We expect a gradual recovery in the coming quarters for the industry and also for our business".
     
    Weak rural demand also impacted the sale of two wheelers. Commenting on the company's mperformance Eicher Motors said: "The two-wheeler and the CV (commercial vehicles) industry continue to face headwinds on account of weak consumer demand".
     
    "In the CV industry, sales have been low due to the weak demand on account of economic slowdown and liquidity and it is also witnessing heavy discounting," the company added.
     
    FMCG giant Hindustan Uniliver, which saw a significant decline in sales volumes during the June quarter, had also said that "the near-term demand will remain subdued given macroeconomic conditions."
     
    Disclaimer: Information, facts or opinions expressed in this news article are presented as sourced from IANS and do not reflect views of Moneylife and hence Moneylife is not responsible or liable for the same. As a source and news provider, IANS is responsible for accuracy, completeness, suitability and validity of any information in this article.
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    MOHAN BHASKAR WAGH

    3 weeks ago

    This is very dangerous situation. It may be Long term also

    Financial surplus of Indian households falling since 2017-18
    Indians, traditionally known to save money, have of late shown a behavioural change in terms of managing their money as their financial surpluses have shrunk in the last couple of years.
     
    A recent Reserve Bank of India (RBI) report said that although currency and deposits constitute more than half of the total assets held by households, their share in total assets have been declining over time and are being replaced by equities and debt securities. 
     
    Among household assets, the share of insurance and pension funds have gradually increased, indicative of the growing risk appetite and portfolio diversification, while the major liability in household balance sheets are loans and borrowings, primarily from other depository corporations (ODC) and other financial corporations (OFCs), the report said.
     
    According to official data, household financial assets and their surplus showed an uptick during 2015-16 on account higher currency and deposits supported by high income growth as India's gross domestic product (GDP) growth touched 8 per cent for the first time during the current decade. 
     
    "The financial surplus of households have shrunk in subsequent years. In 2017-18, both household assets and liabilities expanded but the growth in the latter outpaced the former resulting in further moderation in surplus," as per the the report.
     
    The data suggested that households are connected the most with financial corporations which act as intermediaries to channel their surpluses to deficit sectors.
     
    The report said that "demonetisation had a significant but transitory impact on the instrument used for acquisition of financial liabilities during 2016-17, and a quick reversal in the following year. Increased number of insurance policies and mutual funds units were issued during 2016-17."
     
    Talking of the governments, both in the Centre and states, the report said that on the governments' assets side, equity has the largest share, which is reflective of participation of the central government in corporations, both financial and non-financial. This is followed by deposits held with ODCs, more pronounced in the case of state governments which have accumulated large cash balances, reflecting poor cash management.
     
    The financial resource gap of the general government sector remained stable during the period 2012-13 to 2016-17, widening somewhat during 2017-18. "This gap was primarily financed by the OFCs and ODCs, " it said. 
     
    The resource flow from households, primarily via debt securities, picked up from the year 2014-15. Debt securities make up almost three-fourths of total financial liabilities. These debt securities act as a safe haven for investors and are statutorily mandated for scheduled commercial banks (SCBs) under the liquidity coverage ratio (LCR) in addition to the minimum statutory liquidity ratio (SLR) requirement.
     
    In its conclusion, the report noted that in the recent years, the general government has emerged as the major deficit sector in the economy exhausting a major share of the surplus of households. 
     
    Disclaimer: Information, facts or opinions expressed in this news article are presented as sourced from IANS and do not reflect views of Moneylife and hence Moneylife is not responsible or liable for the same. As a source and news provider, IANS is responsible for accuracy, completeness, suitability and validity of any information in this article.
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    B. Yerram Raju

    3 weeks ago

    Indians are now tuned to debt. Long gone is Y=C+S. Debt is committing an uncertain future. Most individuals enjoy present with retail credit flowing to them for all purposes including leisure travel. The future therefore is bartered for the present. Most consumables and spares are on debt and on uncertain incremental incomes. Banks are jumping the gun and lending. Financial extravaganza is a long term injury.

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