Since making an all-time high on 26 September 2024, the Nifty50 index corrected over the next two weeks. The correction so far has been inconsiderate, with the index giving up just the gains made in September 2024. Meanwhile, the S&P 500 index is at its all-time high, after remaining sluggish and volatile in the previous three months.
The latest Fed rate cut has removed sufficient uncertainty from the markets and the consequent increased optimism among market participants might have driven the S&P 500 to record highs. Unlike the S&P 500, the Nifty50 index was buoyant in the previous three months, likely, in anticipation of the Fed rate cut, which is expected to drive capital flows into emerging markets such as India.
Investors’ unwinding their rate-cut bets might have caused the short correction in Indian markets since the Fed rate cut, as the anticipated event has now materialised. ‘Slowing job gains’ and ‘progress on Inflation’ were endorsed as reasons for the Fed’s decision to lower the target range for the Federal funds rate by 0.5 percentage point, its first rate cut in four-and-half years.
The US inflation rate had a terrifying run over the past three years. It first breached the Federal Reserve’s inflation target rate of 2.0 per cent in March 2021. The US inflation rate kept rising for the next fifteen months finally peaking at 8.9 per cent in June 2022.
However, the Fed’s first rate hike to tame inflation came belatedly, in March 2022, one year after inflation had crossed the target rate. The Fed made up for its tardiness by raising rates by 5.25 percentage points over the next fifteen months – the steepest and fastest rate hike in forty years.
Consequent to the rate hikes, inflation which peaked at 8.9 percent in June 2022 declined for the next fifteen months and finally went below 3.0 percent in October 2023. The Fed made its last rate hike in July 2023. The rates were kept unchanged for the next fourteen months until the latest rate cut in September 2024.
However, although the inflation rate declined below 3.0 per cent in October 2023, it stubbornly refused to decline towards the Fed’s target of 2.0 per cent: the latest inflation rate for September 2024 stood at 2.4 per cent.
The public clamour for a rate cut began a year ago and has been intensifying. Whether the Fed intended the latest rate cut or succumbed to the public clamour is ambiguous. However, it is unambiguous that the Fed’s easy money policy since the 2008 global financial crisis has nurtured a pampered public who wants the Fed to save the day each time a difficulty arises.
The question is: Can the Fed keep on indulging the pampered public using rate cuts and quantitative easing forever?
There is more room for rate cuts as rates are higher now after the steep rate hikes of 2022-2023. However, the threat of increased bouts of inflation will impede the Fed from being too lenient with rate cuts during distressing times, particularly after the harrowing inflation episode of 2021-2022.
During the thirteen years between 2008 and 2021, the Fed followed an easy monetary policy, keeping its policy interest rates very low and augmenting the money supply. The low inflation that prevailed during the period gave the Fed the leeway to adopt such a policy for a long time. The Fed has much narrower room for manoeuvre now.
Extended periods of easy money policy are expected to trigger spikes in inflation. Then why inflation never spiked during the 2008-2021 period has confounded many. Globalisation is touted as one reason for the absence of high inflation during the long easy money policy period between 2008 and 2021.
Inflation is the rise in the price of goods and services. Businesses must raise prices to protect their profit margins when there is an increase in input costs and wages. However, business firms have another option: instead of raising the prices of their goods and services, they could move their production to places with lower production costs.
So, firms from developed countries protected their profit margins without raising prices by moving their production facilities to developing countries, particularly in Asia, where production costs are much lower than in developed countries.
However, we can see a reversal in that trend over the past five years or so – an unwinding of globalisation. Countries that outsourced production now want to bring them back: self-sufficiency, national security, and geopolitical tensions are prominent reasons for this change in stance.
Consequently, frequent bouts of inflation are more likely in the developed world in the future due to the disrupting effects of deglobalisation and the added costs expected from insourcing production. Rising interest rates and high inflation will likely persist for the next one or two decades, impacting both the developed and developing world.
Declining interest rates, low interest rates, and low inflation defined the economic conditions of the past four decades. Investors and other market participants accustomed only to such agreeable conditions will struggle to navigate the disagreeable emerging environment of rising interest rates and high inflation.
However, we have experienced such economic conditions before. During the mid-1940s, at the end of the Second World War, interest rates were near zero in the developed world. After the war, interest rates began to rise for the next four decades finally peaking in the early 1980s. It would be instructive to be aware of the financial markets and economy of those past decades to navigate the emerging times.
As we try to understand the economic and financial conditions of the rising interest rates period from the late 1940s to the early 1980s, we need to be aware of a consequential difference between those times and now. For most of the former period (late 1940s to early 1980s), the economic and financial system operated under a gold exchange standard, whereas now we have a floating exchange rate system.
In mid-1944, when the Allied victory was almost certain, delegates from forty-four countries convened in Bretton Woods, New Hampshire, to decide upon the rules for the new postwar economy. The most significant decision concerning the international financial system made during the summit was that all other countries would peg their currencies to the US dollar, and the US is obliged to exchange the surplus dollar with other countries for gold at $35 per ounce.
The governments of countries outside the US pegged their currency to the US dollar by controlling the flow of money in and out of their countries. They could do so in two ways: 1) raise or lower interest rates; 2) buy or sell either of the currencies to bring the market exchange rate back to the fixed rate. This arrangement brought calm and stability to the global financial system causing trade to boom and economies to prosper: the twenty years from 1945 to 1970 is often referred to as the Golden Age of Economic Prosperity.
The Bretton Woods agreement stabilised the international financial system and contributed significantly to the economic prosperity that followed. But this arrangement, often called the Gold Exchange Standard, had drawbacks.
It constrained other countries from acting against high inflation or economic downturns in their respective countries due to concern regarding the adverse effects those actions could have on the fixed exchange rates. Other central banks’ actions depended more on what the US government or central bank did and less on their domestic economic conditions.
Moreover, this system would work only if the US government had a sufficiently large stockpile of gold to exchange for other countries’ surplus dollars and, additionally, other countries didn’t hoard too many dollars. Unfortunately, this is exactly what happened by the early 1970s: the dollar surplus of other countries outpaced the US’s capacity to exchange them for gold.
Volatility in foreign currency markets increased. Currency traders and speculators bet against many currencies believing that central banks could not hold their currencies to the fixed rates for long. Several countries, starting with Switzerland, had to let their currencies float as they became powerless to hold them to the fixed rates.
Finally, the US reneged on its promise to exchange dollars for gold. The Bretton Woods system, or the Gold Exchange Standard, collapsed and was replaced by the floating exchange rate system, in which the market forces of demand and supply determine the value at which one currency could be exchanged for another currency. The central banks of various countries can (and do) interfere to influence their currency exchange rates, but there are no rules or regulations to adhere to; everyone is free to act out what is in their country’s best interest.
Between 1945 and 1970, most of the world experienced an unprecedented economic boom. The US economy grew at 7 per cent, Western European countries experienced the largest annual GDP growth from 1950 to 1970; in Japan, industrial production grew at double digits; and the economies of East Asian tigers such as Hong Kong, Singapore, South Korea, and Taiwan grew at 7-8 per cent per year.
The widely held belief then was that the government’s actions to ensure full employment and careful economic planning caused the economic boom. Governments running deficits became a norm rather than an exception during the period. Stable exchange rates, benign inflation, the increased economic cooperation that enabled trade to flourish, and global peace brought on by the absence of any major geopolitical tensions are possible reasons that could have caused the economic prosperity of 1945 – 1970.
Unfortunately, we have none of these tailwinds now, except inflation. Inflation seems to have subdued post the 2021-2022 episode, thanks to the steep interest rate hikes by central banks during 2022-2023.
However, although seems to be subdued, higher inflation is more likely going forward as countries move their production for reasons other than costs, which we discussed earlier. Exchange rate volatility became more frequent and common under the floating exchange rate system. Countries are turning more inward hampering global trade. The biggest headwind the global economy is facing right now is the escalating geopolitical tensions caused by the Russia-Ukraine war, the Israel-Gaza conflict, the Israel-Hezbollah conflict, and the increasing possibility of an Israel-Iran conflict.
Let us review the impact of the economic prosperity of 1945 – 1970 on stock prices. The Dow Jones Industrial Average (DJIA) rose from 2,700 at the beginning of 1945 and peaked at 9,600 in December 1965, an annualised gain of 6.55 per cent. But the index declined by 28 per cent between 1965 and 1970.
So, the annualised gain of DJIA during the golden age of economic prosperity, between 1945 and 1970, was 3.85 per cent, almost half of the US GDP growth during the period. The average inflation rate in the US during the 25 years was 3.12 per cent. Once inflation is considered, DJIA remained almost unchanged during the 25 years.
The economic boom of the golden age didn’t translate into a stock market boom: instead, stock prices massively underperformed during the period. Why did it happen so: a study of interest rates during the period might be enlightening.
The golden age period of 1945-1970 was also a period of rising interest rates. The Federal Funds rate rose from around 0.5 per cent in 1945 to around 8.0 per cent by 1970. Similarly, the 10-year US treasury yield rose from 1.7 per cent in 1945 to 8.0 per cent in 1970.
This suggests that stock prices have a minuscule correlation with economic growth but are highly correlated with interest rates, and that correlation is an inverse one: stock prices outperform during periods of declining interest rates, whereas they underperform during periods of rising interest rates.
What causes interest rates to go up or down? During periods of economic expansion, interest rates increase due to the increased demand for credit to finance the investments required to meet the rising demand in the economy. Likewise, interest rates might fall during periods of economic slowdown due to lower demand for credit.
However, credit demand is just one of several factors that could influence the direction of interest rates. A deposit glut in the financial system could cause interest rates to remain low and steady, despite high credit growth. Central banks through their power to set short-term interest rates also could cause market interest rates to go up or down.
Generally, interest rates rose during periods of economic expansion, and declined during periods of economic slowdown or contraction. But there were exceptions to this general trend too. During periods of stagflation – characterised by low growth and high inflation – interest rates might rise if central bankers prioritise inflation control over economic growth.
The economic boom of 1945-1970 might have caused interest rates to rise. However, interest rates kept rising even during the turbulent economic period of the 1970s. Central bank efforts to bring inflation under control largely caused interest rates to increase during the 1970s.
Over the past 125 years, interest rates have moved in cycles: they keep rising for a few decades, then the trend reverses, and they keep declining for the next few decades. From the early 1980s to 2021, interest rates were declining. The cycle has turned now, and interest rates will increase for the next decade(s) if it wants to stay true to history.
Changing economic conditions determine the direction of interest rates. However, whether economic expansion or inflation will drive interest rates higher is unclear. The former is preferred, but unlikely in the present context, because of the increased risk posed by volatile exchange rates, inflation pressures, geopolitical tensions, trade barriers, and retreating globalisation. The latter, though unpreferred, is more likely due to the same reasons.
Asset prices always had a difficult time and have underperformed during times of rising interest rates. That difficulty is exacerbated if inflation, not economic expansion, is the prime reason behind rising interest rates. But that seems to be the future we are staring at.
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