It has now been almost one and a half years of what has been a very aggressive developed market (DM) rate hike schedule. And yet the general economic narrative remains more robust than what most had expected even half a year ago. To be fair, most of this in the DM world is being driven by the US with Europe actually beginning to feel the economic pain more conclusively. However, the US being the largest economy and the keeper of the almighty dollar does matter more to the narrative. And here overall growth remains above trend over 2023 so far as well, even as there is a substantial slowdown from the heady days of the post-Covid recovery and recent data also points to significant labor market rebalancing underway.
The US resilience seems underpinned by the extraordinary fiscal dynamics there. The post pandemic aggressive response, that led to more than USD 2 trillion excess savings with households, is well documented. This was followed by one year of fiscal compression. However, the 12-month trailing deficit as at date again shows a significant expansion in the deficit again. Meanwhile, the Fed’s balance sheet contraction program was interrupted earlier in the year courtesy the US regional banking crisis. Another curious aspect of this cycle has been that while bank lending conditions have been tightening significantly in the US and Europe, this has as yet not translated into much wider credit spreads even as volumes in that market may have come off.
Mind the Gap
We refer to two concepts here: Nominal GDP growth rate (G) and nominal interest rates (R). The latter can be proxied by either nominal policy rates or bond yields. The thesis is that G minus R matters both for incentive to take on fresh debt as well as for ease of servicing existing debt (once refinanced to the current R). More generally, it is a useful way of denoting the relative tightness of interest rates. Real rate (nominal rate over any time period minus expected inflation over the same period) is another measure but it doesn’t directly take the state of current growth into account.
While the illustration below pertains to the US for the reasons mentioned above, the observations hold for a number of other economies as well.
The chart has to be interpreted carefully since the post Covid rebound obviously flatters the nominal growth rate. However, what is noteworthy is that G minus R is now getting to be quite narrow. Indeed if one uses nominal policy rate as a measure, this is now the narrowest we have seen outside of crisis periods in the last 15 years. Thus, probably for the first time in this cycle, interest rates in the US are now genuinely restrictive. Alongside much tighter bank lending conditions and a pick up in contraction of Fed’s balance sheet, this should start to show much more forcefully in economic activity over the next couple of quarters going ahead. However, this still leaves fiscal dynamics unaddressed. We turn to that next.
As noted above, US fiscal deficit has picked up again since late last year. However, this has not just been due to higher spending but also owing to a marked fall off in government receipts. In particular, individual income tax collections have been massively hit, contributing significantly to the federal government’s fiscal deficit expansion. While we admit to having no direct insights on this, a lot of this hit seems on account of the postponement of income tax payment dates in key states on account of natural disasters, etc., earlier in the year. As the payment deadlines come through, it is expected that tax payments will resume thereby leading to a significant narrowing to the monthly deficit run-rate. Additionally, there was an earlier student debt loan waiver that now needs to recommence. This will further draw repayments to the government.
While the fiscal dynamics discussed above pertain to the ongoing flow of resources, another major point has been the stock of excess savings with the consumer courtesy the aggressive fiscal response from the government over the first two years of the pandemic. Views differ on how much of these excess savings are still left or even if mechanically tracking the drawdown is the right way to forecast future consumer spending. However, for whatever it is worth, there is a recent paper from researchers at the Federal Reserve Bank of San Fransciso (https://www.frbsf.org/our-district/about/sf-fed-blog/excess-no-more-dwindling-pandemic-savings/ ) that concludes that more than USD 1.9 trillion of the estimated accumulated excess savings of around USD 2.1 trillion have already been drawn down by households, leaving less than USD 190 billion of excess savings remaining. Note: excess savings here is defined as the difference between actual savings and the pre-recession trend. If true, then this points to a substantial upcoming drag on US consumer spending.
Jumping context a bit, we now turn to some observations on India’s evolving fiscal dynamics for the current financial year.
A Brief Look At India’s Recent Fiscal Developments
India’s macro-economic resilience is well documented and persists, notwithstanding the observations presented below. The objective of the current exercise is to examine the likelihood of continued support to growth from government spending at the intensity seen since the start of the financial year.
The table above shows revenue and spending trends for Apr – July period this year versus the same period last year. Further, we have projected what the growth in these needs to be for the rest of the year (versus same period last year) if the government were to attain budgeted numbers on each of these items. The following observations seem important:
- Gross tax revenue growth has been quite muted thus far and needs to pick up very substantially from here on (much above likely nominal GDP growth rate) for the rest of the year.
- Total expenditure has to slow down considerably from the heady rates witnessed thus far if budget numbers are to be met. This particularly pertains to revenue spending, which is the majority component of total spending. Furthermore, it is quite likely that this order of adjustment may be neither possible nor desirable. In that case, the run rate on capital spending may need to come off significantly.
- While still relatively early days, we need to be alive to a significant risk of fiscal slippage in the current financial year. Notably, however, this isn’t likely to be a macro worry since the current account deficit that represents the aggregate savings–investments gap should still be well behaved. More likely, the relevance will be only for the bond market unless the order of expansion is more than currently envisaged.
All told, with global growth prospects ambivalent, fiscal impulse likely to slow appreciably, and an anticipated hit to discretionary consumption from the recent food shock, there are potentially some headwinds to India’s cyclical growth ahead as well after a very robust first half of the year. That said, relative growth will likely still be attractive and the structural drivers remain intact.
The dominant investment narrative remains pro-growth and pro-risk, as it has been for most of the current year. Concurrent data as well as investment performance has supported the narrative. In such a scenario, it is always difficult if not dangerous, to present the counter-point for a variety of reasons. One, inflection points are notoriously difficult to catch and being too early can be punishing. Two, the counter-point is after all a view and indeed can be plain wrong. However, what is also noteworthy is this: because the dominant narrative is anchored in concurrent data and price action, it is natural to attribute a higher probability of its continuance even as it is recognised in theory that the inflection point by definition means a break in previous trend and thereby a turn in concurrent data. This is especially true if continuance happens despite data suggesting inflection, climbing the historic ‘wall of worry’ as it were. However, if this phenomenon is recognised then the best way to guard against it is to keep a non-discretionary component in one’s asset allocation that is consistent with the counter-point.
The discussion above is arguing for the counter-point, with all its accompanying hazards as mentioned here. A good way to balance perspective is to have a healthy amount of quality fixed income in one’s asset allocation, something that has become an increasingly rare commodity ever since the tax change for debt mutual funds.
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Staying The Course - Monetary Policy Review February 2024
RBI / MPC kept all rates unchanged as expected. The surprise here was rather external MPC member Prof. Varma voting for a 25 bps rate cut....