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The present dilemma of central banks - Views on News from Equitymaster
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  • Nov 24, 2009

    The present dilemma of central banks

    Stockmarkets received a severe drubbing last year when the global financial crisis unfolded. But the pace at which the markets have rallied this year would surely leave any investor breathless. The main reason that seems to have sparked this recovery is the sense that a global recovery is beginning to take shape in most parts of the world. However, is this recovery really sustainable? Or is it being propped up by the stimulus packages announced by various governments?

    If one were to look at the areas where improvement has been visible, then the robust growth in corporate profits surely stands out. However, this has come about due to cost cutting measures adopted by companies to tide over the crisis rather than any meaningful growth in the topline. Fallen commodity prices also aided the bottomline growth. This, however, means that businesses for the time being are not really growing. And therefore a question mark arises over the sustainability of these profit margins.

    In the US, stimulus packages were announced with a view to spur consumption. But the same has not really happened the way the government anticipated. The reason? The average American is wary of loosening his purse strings in a weakening job market. Similarly, corporate are not really spending on capex. They are instead are using the cash to retire debt and generally strengthen their balance sheets.

    Meanwhile, certain economic data released by the US belies the strength of the recovery. For instance, the job market has not improved and unemployment has soared to 10.2%. So consumption is not likely to pick up anytime soon. This has prompted the Fed to keep interest rates low and has sparked the stupendous rally in the stockmarkets, especially in the emerging economies.

    Emerging economies like India and China have been growing at a much stronger pace as compared to their Western counterparts. In these countries, an increasing trend in benchmark inflation has warranted a rise in interest rates in the near future. Not just that, emerging markets have been facing a deluge of foreign money due to the tepid outlook in the developed world. This has further raised the possibility of higher inflation. So, in a scenario where the US is keeping its interest rates low, the interest rate differentials between the US and India would widen. This would then stoke the foreign inflows further.

    Central banks especially are having a tough time gauging the true economic picture. The very fact that they are keeping interest rates low means that probably they are not confident of the strength of the global recovery. This then questions the rally in the global stockmarkets. At the same time, there is the danger of central banks not anticipating a real recovery when it does occur. If that happens, the low interest rate regime will form asset bubbles and fuel inflation. Indeed, the dilemma for central banks has never been more pronounced than it is now!



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