Interview

«Central Banks Have to Start to Move»

Raghuram Rajan, Professor of Finance at the University of Chicago and former Governor of the Reserve Bank of India, believes the risk of persistently high inflation is significant. He warns that financial markets are underestimating the possibility of a substantial rise in interest rates.

Christoph Gisiger
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The news is troubling: In the U.S., inflation rose further to 7.5% in January; again faster than expected and the highest level since the early 1980s. Bond market yields are rising, with interest rates on ten-year treasuries trading higher than pre-pandemic levels for the first time.

Despite these violent movements, equity markets remain surprisingly calm. The S&P 500 is barely more than 6% below its record high of early January – and that, in Raghuram Rajan’s view, is precisely the problem.

«Central banks have to switch to a different environment where they have to signal quite strongly that they mean business in going back to their old task which was containing inflation,» says the Professor of Finance at the University of Chicago and former Governor of the Reserve Bank of India. «Unfortunately, the perception that central banks are unwilling to do what it takes on the downside - not on the upside - makes this somewhat harder,» he adds.

Dr. Rajan knows what he is talking about. In the summer of 2005, he caused a stir when he warned against excesses in the banking system in front of the assembled financial elite at the economic symposium in Jackson Hole. He was sharply criticized back then, but today he is one of the most renowned economists of our time.

In an in-depth interview with The Market/NZZ, which has been lightly edited and condensed for clarity, he explains why he sees a real risk of persistently high inflation and what this could mean for financial markets. He also comments on China’s ambitious reform plans and on structural changes in the economy caused by the pandemic.

«We sort of stopped thinking about countries like Italy. But if we come out of the pandemic and interest rates are not at 1% or 2%, but at 4% or 5%, what happens to public finances? Obviously, the biggest risks are always the ones you don’t see. But this is a risk we haven’t paid attention to for a long time»: Raghuram Rajan.

«We sort of stopped thinking about countries like Italy. But if we come out of the pandemic and interest rates are not at 1% or 2%, but at 4% or 5%, what happens to public finances? Obviously, the biggest risks are always the ones you don’t see. But this is a risk we haven’t paid attention to for a long time»: Raghuram Rajan.

Photo: Bloomberg

Professor Rajan, in your latest essay for Project Syndicate you argue that we’re approaching «the end of free-lunch economics». What do you mean by that?

In developed countries, we’ve grown used to central banking as effectively having an unlimited capacity to do things that seem pleasant. In other words: We can keep interest rates really low which, of course, is not pleasant for the savers, but quite pleasant for borrowers and more generally for the economy. Meaning, we can buy assets and that increases asset prices. Typically, those who own assets enjoy that, whether it’s houses or financial assets. Overall, there has been very little constraint on the leeway to do more in terms of stimulative policies because of the low level of inflation.

And how does it look today?

Central banks have to switch to a different environment where they have to signal strongly that they mean business in going back to their old task which was containing inflation. Unfortunately, the perception that central banks are unwilling to do what it takes on the downside – not on the upside – makes this somewhat harder. For example, initially there was a significant adverse market reaction to Chairman Powell effectively saying that the Fed will do what it takes to contain inflation. But more recently, a number of Fed presidents have dialed back somewhat, essentially saying: «We will be more contingent, we are obviously not going to tank the economy.» This reaffirms the market’s hope that we can still celebrate without any adverse reaction.

In concrete terms, what does this mean for monetary policy in the U.S.?

If the Fed is serious, it will have to do more in terms of raising interest rates and policy tightening before the market finally accepts that this time is a little different. That is part of the problem: In the past, the Fed could do a fair amount of tightening just by signaling. But this time, it may not be enough given how used markets are to easy Fed policy.

Why do you think the environment has changed fundamentally? After all, might inflation not subside again during the course of the year?

None of us can bang on the table and say «we’re right», because we don’t know. There are signs that suggest that this time is different, and it’s not just about the transitory aspects. Sure, supply bottlenecks look pretty problematic, and it can get worse if China orders new lockdowns. But one important reason for why this time might be different is that the labor markets themselves look tighter than they were before. On one hand, this tightness likely has something to do with the nature of the recovery: For instance, in the U.S. there are some areas like New York City which still have high levels of unemployment, around 9%. But other areas have very low unemployment. So there are both geographical as well as sectoral aspects, since there is more unemployment in high-contact services and less in manufacturing.

And on the other hand?

There is also the sense that people are more reluctant to work in low-wage, high-contact services. Plus, there has been a fair amount of retirement. There is an ongoing search for better employment, the so-called Great Resignation. If we put all these factors together, I think the labor market has changed. Moreover, there is also broad-based public support for higher wages, especially at the lower end, I mean more tolerance for strikes and unions. They will be needed, but they will push up labor costs and inflation.

At the same time, however, a massive counter-reaction to the bottlenecks is taking place on the supply side. Capacities are being built up everywhere, especially in the semiconductor industry. Won’t that have a dampening effect on prices and inflation in the future?

The flip side of the shortages disappearing in manufacturing will be that the service sector opens up fully. Hence, there will be a fairly strong demand for workers in the service sector. The question is where are these workers going to come from, if labor markets are already tight. To some extent, service prices are contained by weak demand. So why wouldn’t we believe that some manufacturing prices will come down, but service prices will move up as demand rebalances? That’s why I’m not sure that it’s a given that everything will be hunky-dory.

Are there other reasons for stubbornly high inflation?

Globalization used to be a constraint on wage demand: If workers are too aggressive in demanding wages, a manufacturer could move the factory to Mexico or China. In today’s environment, it’s not politically feasible for employers to make those kinds of statements. That’s another aspect that makes the current environment potentially more inflationary for a little longer. And finally, this is Larry Summer’s point, the extent of fiscal spending was almost an order of magnitude higher than last time around. In the U.S., the government spent close to six trillion dollars in stimulus even without President Biden’s Build Back Better plan.

Are there also credible arguments that the inflationary surge could be easing?

First, the pandemic certainly has created disinflationary impulses in the emerging world. There has been a lot of scarring. Second, one also could argue that China is undergoing some significant changes, and that could be disinflationary as well. The Chinese are trying to revive their economy by pushing the usual levers, easier money etc. But it’s an open question whether they can revive the economy as easily without a strong construction sector. Those are the two factors that make me sort of hesitant in saying «we are going to get roaring inflation.» But as of now, given what we know, inflationary impulses are very strong, and central banks have to start to move.

Just last spring, Fed Chairman Powell assured us that interest rates in the U.S. would not be raised for many years. Now, markets are expecting a double rate hike of 50 basis points at the next Fed meeting in mid-March. Later in the year, the Fed is also expected to begin reducing its balance sheet. Is the Fed behind the curve?

Times are very uncertain, and even politically, the Fed is a little bit in a bind. It moved to a new policy framework at a time when the problem was low inflation. By doing that, it bought itself a fair amount of time: It didn’t have to raise interest rates as soon as it saw inflation. It could wait, practice average inflation targeting etc. Therefore, to jump the gun and raise interest rates, would have been politically problematic. In addition to that, almost always when the Fed starts a program of raising interest rates it contracts economic activity. And keep in mind: Congress just added enormous amounts of fuel to the economy through stimulus measures and bailouts. If the Fed reverses these measures with an extreme move in interest rates, it is not going to be in a pretty situation either. As a result, the Fed really had no option politically, but also economically than to wait and see if the recovery was really strong. Once the data from November and December showed it was strong even though the coronavirus was still around, the Fed looked through that and basically said: «We have to act now.»

How big is the danger that the Fed will now commit a monetary policy mistake?

If anything, the mistake may be the feeling that we didn’t know how to deal with low inflation, but we know how to deal with high inflation. I think we underestimate the political will needed to fight high inflation, and the kind of high interest rates one might need if inflation stays elevated. In past inflationary episodes, you usually had to take the nominal interest rate a percentage point or two above the inflation rate in order to get it down. Today, five-year inflation expectations are at 2.8 to 2.9% in the U.S. Add a percentage point to that, and you need the Fed target rate to go up to 4%. Nobody is thinking about policy rates going up near 4%.

Does this mean the stock market is misjudging the risk of persistent inflation?

I come from the University of Chicago, so it’s very hard to say anything is definitely mispriced. The truth is that some segments of the stock market were significantly overvalued, and over the last few months, the air has come out of some of that. If more air has to come out, I don’t know. What’s clear is that the markets don’t seem to suggest the Fed will have to do a lot in terms of policy tightening to get inflation under control. Put differently, anything that requires the disinflationary impulse to be within the U.S. – meaning the Fed raises interest rates which collapses stock prices, contain sentiment and demand and slows down the economy – is not being priced in stock prices. So if the Fed has to bring inflation under control, it has to indicate that it is open to any part that is messy.

How then can this relatively nonchalant behavior of investors be explained?

Maybe the markets know something we don’t: That disinflationary pressure from the rest of the world will contain inflation in the U.S. That’s possible, and maybe what China is doing will be the key catalyst there. But none of us can predict exactly what’s going to happen in China either, because they’re also doing something that’s different for the first time.

What are you referring to?

In many ways, these are huge actions, and you can see the connection between some of them: China wants to be less dependent on exports and investment. Exports, because the rest of the world is becoming unfriendly, so you don’t want to be dependent on the rest of the world. Investments, because you basically invested everything that you needed to invest. Take housing for example. In China, the average residential space per person is essentially the same as in France, but China has only one third of the per capita income. Plus, how many high-speed railways do you need? So if China wants more growth, it needs to increase consumption which implies an increase in wages. And this means they need to move away from the old economy which was based on cheap labor and cheap wages.

What does this mean for China’s economic policy?

That means focusing on the private sector, technology etc. But here they have another problem: Some of these high-tech areas are monopolies, and they are very powerful and may impinge on the Communist Party’s own position. Also, they may harm households in the sense that they absorb a fair amount of household spending. Look at those tutoring platforms for instance. If middle-class households have to hire expensive tutors, that reduces household spending. So in China, there is a common theme: Let’s crack down on the old part of growth and try to create new parts of growth.

Can this ambitious strategy work?

There are so many fronts: taking on the external sector and the construction sector, trying to increase consumption, trying to reduce the emphasis on low wages and lots of capital. These are reforms that would take a lifetime in other countries. China is trying to do it quite rapidly – and that’s where the worry is: That they can’t handle it. And if you look at China’s construction sector, the bad debts there dwarf the bad debts in the U.S. mortgage market at the peak of the housing bubble in 2006, and we had a global financial crisis back then.

At the time, you were one of the few observers who warned early on about systemic risk in the financial sector. Where is the greatest danger this time?

The big risk is that we have gotten used to a pillar of very low interest rates. Across the world, public sector balance sheets have become more and more strained because of the debt they have taken on. Lots of economists, like Olivier Blanchard for example, have been saying that’s fine: Since interest rates are so low, you have more space to spend. But what happens when interest rates rise? It’s not as if this debt is really long-term and doesn’t have to be refinanced quickly. In fact, a lot of public debt is actually quite short-term. We sort of stopped thinking about countries like Italy. But if we come out of the pandemic and interest rates are not at 1% or 2%, but at 4% or 5%, what happens to public finances then? Obviously, the biggest risks are always the ones you don’t see. But this is a risk we haven’t paid attention to for a long time.

In the aftermath of the Great Recession of 2008/09, high sovereign debt was primarily an issue for Europe and the United States. How are emerging economies like India dealing with the challenge of stubborn inflation today?

In anticipation of times getting more difficult, emerging markets generally have responded by raising interest rates across the board. Examples are Brazil and Russia. For emerging market central banks, the danger comes when you’re torn between your mandate to control inflation and the desire to support the fiscal authorities during this difficult period. When you’re torn between those two mandates, you can’t fulfill either because in trying to help the fiscal authorities, you’re losing credibility as a central bank. Then, interest rates start going through the roof, and that hurts the fiscal authorities. So as long as there is a sense that you will act in time and reasonably, you can contain the rate increase to a modest amount. But when you’ve lost credibility that you will contain inflation, then interest rates can shoot up much higher.

Since last spring, the dollar has also risen substantially. How does this development affect emerging markets, where loans are often denominated in dollars?

That is usually the route through which a stronger dollar affects emerging markets. India doesn’t have much dollar denominated debt, but other emerging markets have, and that’s a source of concern. One reason it propagates widely when the Fed raises interest rates is because of dollar exposure. The difficult part is that the need to tighten policy in emerging markets will be driven not so much because the local economic conditions warrant it, but because it is meant to head off the outflow of capital and the depreciation of the exchange rate that might result from being out of sync with the monetary policy in the U.S. That has always been the problem with the spillovers from Fed policy. But you can’t fault the Fed for moving too early. That’s the problem. The Fed has to move, it can’t just keep waiting.

The fact that the US and Europe are now facing stubborn inflation for the first time in decades also has to do with the structural change the pandemic has brought to the economy. How do you perceive this change?

Especially through the pandemic, we are seeing a number of forces strengthening. One is this worry about the outside: Globalization is a good thing, and it certainly has helped by bringing vaccines to parts of the world where they haven’t been produced; probably less effectively than it should, but it has helped. Then again, globalization has also created complications: The supply chain of a manufacturer is affected by events that happen 5000 miles away. So net-net, I think the pandemic has strengthened protectionism rather than weakened protectionism.

Where do you see further impacts?

The pandemic has increased the possibilities of spreading work. Service at a distance, work from home, can allow for spreading economic activity through a country. One of the big problems, which I refer to in my recent book, «The Third Pillar», is the concentration of economic activity in big cities, leaving many communities without a strong economic base. That has been part of the reason for the hostility towards globalization and immigration.

Does this mean that technological change in the wake of the pandemic is opening up opportunities for new economic models?

With the technological change that has happened as a result of the pandemic, we have an opportunity to have people working at a distance, to have incomes being generated in communities even if the activity is not performed for that community. We need to build on that idea. It’s quite important that we can strengthen the community so people feel a sense of belonging, a sense of identity, without necessarily erecting huge barriers against globalization and immigration. In this regard, Switzerland, where decentralization is pretty effective, provides many lessons. Certainly, moving more powers to the cantons and to the municipalities like Switzerland does, can help in other countries to ease some of the feeling of powerlessness that people in communities across the world experience.

That sounds surprisingly optimistic.

At every point, we have many challenges, but we also have many opportunities. Technology throws up so many possibilities. This may sound corny, but as long as we maintain our sense of brotherhood and humanity in using that technology, we can really do a lot better. But when we try to appropriate technology for a small group, we start creating more problems. Maybe the pandemic will force us to think about those opportunities, at least going forward - and that will help us collectively overcome big problems, including that of climate change. So I’m always optimistic.

Raghuram Rajan

Raghuram Rajan is the Katherine Dusak Miller Distinguished Service Professor of Finance at Chicago Booth. He was the 23rd Governor of the Reserve Bank of India between September 2013 and September 2016. Between 2003 and 2006, Dr. Rajan was the Chief Economist and Director of Research at the International Monetary Fund. Dr. Rajan’s research interests are in banking, corporate finance, and economic development, especially the role finance plays in it. The books he has written include «The Third Pillar: How the State and Markets are leaving Communities Behind» (2019), «I do What I do: On Reform, Rhetoric, and Resolve», (2017), and «Fault Lines: How Hidden Fractures Still Threaten the World Economy», for which he was awarded the Financial Times-Goldman Sachs prize for best business book in 2010. Dr. Rajan is a member of the Group of Thirty. He was the President of the American Finance Association in 2011 and is a member of the American Academy of Arts and Sciences.
Raghuram Rajan is the Katherine Dusak Miller Distinguished Service Professor of Finance at Chicago Booth. He was the 23rd Governor of the Reserve Bank of India between September 2013 and September 2016. Between 2003 and 2006, Dr. Rajan was the Chief Economist and Director of Research at the International Monetary Fund. Dr. Rajan’s research interests are in banking, corporate finance, and economic development, especially the role finance plays in it. The books he has written include «The Third Pillar: How the State and Markets are leaving Communities Behind» (2019), «I do What I do: On Reform, Rhetoric, and Resolve», (2017), and «Fault Lines: How Hidden Fractures Still Threaten the World Economy», for which he was awarded the Financial Times-Goldman Sachs prize for best business book in 2010. Dr. Rajan is a member of the Group of Thirty. He was the President of the American Finance Association in 2011 and is a member of the American Academy of Arts and Sciences.