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.).