Haslinda Amin: As we emerge from the pandemic, we are seeing a divergence in monetary policy. The Fed remains patient. Despite the fact that Fed officials are split down the middle, the Bank of Korea raised rate, the Bank of Thailand may cut, Bank Indonesia may do the same and the Reserve Bank of New Zealand was derailed by one COVID case, a divergence, despite the fact that central banks around the world are mulling over the same question, where are we in this economic recovery? To taper or not to taper? Is inflation transitory, as the Fed would say? And we have just the right man to put all those things in perspective. Ravi has expertly navigated the monetary policy in Singapore. And Ravi, always a pleasure to have you, and we want answers. So we have a dovish Fed, not in a hurry to exit stimulus, is this a stance that reflects the economic and financial progress that we have made in the last eight to ten months.

Ravi Menon: Central bankers have a reputation for being utterly boring, and I will keep up to that reputation. I think for all of us in the financial markets, this is our number one question: what is the likely path for inflation because that’s going to determine monetary policy actions. Why is it so important? Because since the global financial crisis, the world has been very used to highly accommodative monetary policies, and liquidity has kept the markets buoyant. It has conditioned a whole range of behaviours in the financial markets. So the upcoming tapering, or gradual unwinding, has huge significance. The one thing that will press the hand of central bankers, is if there is a clear risk of inflation rising. Traditionally, central banks act pre-emptively to combat inflation because it is easier to contain price pressures earlier than later. And that’s why this question is so relevant. It’s not as if we have an inflation problem in the world. What we are seeing is a rise in inflation across countries, and the question is whether that’s likely to continue into next year.

We hear many of the major central banks saying that the inflation we are seeing is transitory. I think if you unpack it, there are two dimensions to what they mean by transitory. One is purely statistical, a very low base last year. Last year, the world went into a severe recession, activities froze. So inflation was low, price levels were low. So, as the economy recovers, you’re going to get a headline inflation rate that looks high. The Fed is telling us, look through that and see where inflation settles once the base effects are taken away. That is easy enough to understand and most people can calculate the base effects.

The second part of what the Fed means by transitory is the mismatch between demand and supply. So, you have demand picking up with all the stimulus and the reopening of economies amid increasing vaccination rates. You see this in America most strongly, you are also seeing that in Europe, and China of course has been off the starting blocks earlier. But you still have supply disruptions. So this is where the argument becomes more tricky. How long is the supply disruption going to take to resolve itself? So transitory has many meanings. So the first question you should ask is, how long is transitory?

Haslinda Amin: How long is transitory?

Ravi Menon: Base effects wash off over the course of the year. When you have a supply-demand imbalance, you have to look at where those imbalances are. If you look at semiconductors, there is an imbalance. Production capacity was strained in the earlier part of the year and you could see prices rising. You see this in freight rates, cargo rates, and a range of other indicators that suggest that supply has been disrupted, and not fully restored, but demand has come back in a big way. When you have rising demand meeting supply constraints, you have price increases. We need to look at where these price pressures are coming from, and how long we think the supply response would take. If the supply response is quick enough, then the demand-supply gap will close, and inflation pressures will abate.

Haslinda Amin: But then there is a lack of clarity. You talked about chips. I mean, now the lag time is twenty weeks. So all the more makes it problematic and complicated in trying to see how long this transitory period really is.

Ravi Menon: It varies across industries. The latest on chips is that new supply is coming on stream again. When you have shortages, the production response can be quite quick in some industries; and slower in others especially where there are still disruptions in the supply chain. I think this is what we need to watch. Rather than look at the headline numbers, we should examine these supply responses. If by the end of the year, we don’t see much of a meaningful supply response, then we would ask ourselves, is this upcreep in inflation going to persist into next year?

There is a third element to consider: what is the central bank’s appetite for higher inflation? There has been talk that going above 2% inflation is not a strict no-no, because you’ve been below your target for so long, and with the new paradigm that the Fed has been talking about, you could actually go above 2% for a while. So, even if inflation were to edge above historical norms, if it were to be accommodated, then you wouldn’t necessarily have as strong a monetary policy response.

Haslinda Amin: The thing is even Fed officials can’t agree. What is the weight of a mis-step? And what’s your own take on whether inflation will persist to next year? What’s your own assessment?

Ravi Menon: One of the things that the Fed has been saying is that even if the headline inflation rate were to go up, if inflation expectations are well-anchored – meaning that inflation could creep towards 3% over the course of next year but expectations remain anchored at around 2% – then the problem would be resolved over time. This is because inflation is very much an expectation-driven phenomenon. So the Fed is watching very closely what the financial markets are telling them about inflation expectations and what people are telling them through consumer surveys as to where they think inflation is heading. When you have inflation that’s unhinged and unanchored, then you will have increasing demand for wages, and that will translate into broader price pressures.

Another area to watch closely will be the labour market. Traditionally, that’s where inflation has its genesis, because with a tighter labour market, wages go up and that in turn feeds into price increases. In the current conjuncture, it’s rather difficult to make sense of the labour market in the US. The unemployment rate is lower than historical, but you also have a reduced labour force participation rate. So, as the economy opens up, will more people come back to join the labour force, and then create more slack? Again, we don’t know. So I don’t envy the task of the Fed in making sense of all these factors.

Haslinda Amin: Were you surprised how they decided to be patient? I mean, I think almost everybody here cheered because it suits the market, but were you surprised as a central banker?

Ravi Menon: No, it’s been very consistent with what the Fed has been saying so far.

Haslinda Amin: But in the lead up, we have the likes of Kaplan, Bullard and George saying whether it is the time.

Ravi Menon: There are many good Fed watchers here. So all these regional presidents giving their take on things, useful, but most of us know we listen to the Fed Chairman, the President of the New York Fed and the Vice Chairman. And as long as that consensus holds among the three of them, that would be the view that the Fed as a whole takes. So, yeah, not surprised so far.

Haslinda Amin: Is it time to take the Fed as the key element that will dictate your policy? For the other central bankers outside of the US, do you take that into consideration, how much of that do you take into consideration?

Ravi Menon: Christine Lagarde and her colleagues on the ECB Council have said that the situation in the Eurozone is different from the US. They don’t want to be coloured in the same broad brush stroke, so that even if the Fed were to tighten, the ECB wants more time. The ECB will look at its own conditions. Of course there will be implications across global financial markets from any change in the Fed’s policy stance, but if the Eurozone is seen as being in a different phase of the cycle, with less inflation pressures, it can stake a separate

position. And then you have range of other economies.

In this part of the world, or more broadly for most emerging economies, the central fear is this, that if the Fed were to move faster or earlier than the markets have priced in, you would have volatility in financial markets. Fed communications therefore become very important. If the markets were to be surprised by the Fed and were to take on a strong risk-off perspective, then emerging markets will face the brunt of any capital outflows, exchange rate pressures, possibly even dollar funding challenges as we’ve seen in the past. It could be a replay of the taper tantrum of 2013 when the mere prosect of Fed policy tightening unnerved financial markets. The risk now is that we are seeing renewed outbreaks of COVID-19 in the region. The Asian economies, which got off to a good start in the early part of this year, are now facing some economic slowdown and would much like to preserve easier monetary conditions. But if you have the threat of capital outflows or dollar funding shortages – as has happened before – these countries may have to tighten monetary policy faster than they would have liked.

But having said that, I think the situation now is not quite the same as it was during the taper tantrum. The policy space for Asian economies is larger now. During the taper tantrum, many economies in the region had weaker external positions and their macroeconomic management was tested. I think they are in a better position today, reserves are larger and can help dampen volatility and there has also been a fair amount of exchange rate flexibility for some time now. As the governor of the Bank of Indonesia puts it, they have more tools now to deal with the situation, what he calls “triple intervention”.

Haslinda Amin: But having said that, is there a sense that emerging markets are finding it increasingly difficult to wind themselves off emergency measures? When you talked about unprecedented times, we have shared burden in Indonesia between the government and the central bank and that is persisting longer than expected and perhaps is a reflection of what’s happening?

Ravi Menon: It’s not unusual by the standards of what’s already happening in the advanced economies. Although in the advanced economies, the central banks are acting quite independently from their governments, the fact is that the central banks’ asset purchases have been a major source of financing for fiscal deficits. It’s not monetary financing in the strict sense of the term because they’re not buying government securities from the primary market, but a high share of the government securities in the secondary market is being gobbled up by central banks. So in a sense, you have a combination of monetary and fiscal policy to deal with an unusual situation.

I think in some of the emerging economies, what you’re seeing are more formal arrangements between governments and central banks. If you take Bank Indonesia for instance, their willingness to buy government securities at the long end, which is what QE is about, means they can lower the slope of the yield curve while keeping policy rates unchanged at the short end. Now, can all emerging markets pull that off? Well, it depends on their own fundamentals. I do think that is more policy space now because many emerging economies been preparing for the eventual tightening of monetary policy, for a long while. So while the risk of volatility and capital outflows is present, it is probably not as pronounced as was the case a few years ago.

Haslinda Amin: Where are we in this global economic recovery, taking into account the data out of China. Just today, non-manufacturing PMI was under 50, I think at 49 point something. So it’s pretty precarious. It suggests slow-down. How confident are we about this recovery?

Ravi Menon: I’m a little more confident that China’s economic recovery is on firmer ground. You will have month to month slippages. They are also having renewed COVID-19 outbreaks, and their vaccination rate is still somewhat behind. But I think if you look at the overall Chinese economy, it is on a steady recovery path. The US, of course, is seeing quite an acceleration of economic activity: quite remarkably strong growth and seems fairly resilient. Partly to do with vaccination rates, which I think will probably plateau to around two-thirds, at best 70%, not quite herd immunity. So right now, there’s still quite a tragic situation in many parts of the US with infections and fatalities. But the US has made up its mind, no matter what the infection rates are, they are not going to shut down their economy. They take localised measures to restrict mobility; these practices vary widely across states but because there’s no federal mandate, the economy will remain largely open and chug along.

In the US, there is public acceptance that the country will just ride through the pandemic and not shut down the economy. It’s a position most countries don’t take because their risk appetite is different. Europe is also getting there: even without the requisite vaccination thresholds for herd immunity, they are transiting into endemic COVID. I think in other parts of the world, especially in Asia, because vaccination rates are lower, they can’t treat renewed outbreaks lightly because it will have a heavy toll on human lives and impose strains on the public health system. So the dual economy recovery story is quite real – for the advanced economies, because they have been able to procure vaccines and they have the logistics and administrative capacity to administer them widely, they can bear a higher level of risk by opening up and staying open. Whereas in Asia, many countries have had to repeatedly scale back economic activity in the face of new outbreaks. This state of affaits could last into the early part of next year, until a degree of herd immunity is probably reached.

Haslinda Amin: So Delta may not derail China’s recovery, but Delta may derail recovery closer to home. What does it mean for Singapore being such an open economy? Is the new growth projection of 6 to 7% at risk?

Ravi Menon: Well, we just revised it to 6-7% a few weeks ago.

Haslinda Amin: Yes exactly, but then we have to remember that there’s a new variant from South Africa.

Ravi Menon: New variants – really nobody knows, right? It remains a tail risk we cannot ignore, because the longer the infections persist in the world on a wide scale, the chances of getting variants that are vaccine-resistant, are higher.

But if you set that aside and deal with the variants that we know – Alpha up to Delta – I don’t think they will derail the growth momentum we seeing now. The 6-7% growth forecast is premised largely on the Chinese economy and the US economy continuing to recover. If you look at the final demand for Singapore’s exports, although ASEAN is very important to us, US plus China is larger than ASEAN. There’s a lot of intra-ASEAN trade – supply chains are all linked – and it’s quite interesting that when you had the lockdown in Malaysia earlier, the impact on Singapore was less than initially feared. Although private sector economists had already upped their forecast just looking at Q1 and early signs in Q2, the government held back revising the forecast in May, only because of uncertainty about the impact of the Delta variant. We were going through a bad patch and we could see what was happening in the region, and there could have been negative spillovers from the region. As it turned out, we are now largely out of that. Not that infection rates have come down – on the contrary, they are now very high at about 150 new cases and rising – but vaccination rates are much higher, so we have more confidence.

The supply chains to the region have proved to be more resilient than we had feared earlier in the year. It’s quite amazing how corporates and businesses have been able to nimbly find alternative sources, because of what happened last year. Basically, supply chains have become more resilient and flexible, which is what we would like to see. While there will be some dislocations because of persistent supply shortfalls and shipment bottlenecks which bear watching, by and large, because final demand for manufacturing, storage and logistics, financial and ICT services remains strong, the bulk of the external facing part of the economy is doing quite well under the circumstances.

Haslinda Amin: What’s the biggest risk to Singapore’s economy then?

Ravi Menon: A new variant. Because much of the scenario that I’ve just described, and I’m not being deliberately optimistic, rests on the effectiveness of the vaccines. Vaccinations have helped, not so much to reduce infection rates – especially against Delta – but in reducing fatalities, hospitalisations, the need for oxygen, and so on. That gives us more confidence to move to an endemic scenario. But all that can go wrong if there is a new variant that is resistant to vaccination in the sense of making you very sick. Then we are back to 2020.

Haslinda Amin: When we last spoke, we talked about how we could see deep scarring for 10 to 20% of the economy. Is that still the case?

Ravi Menon: Maybe not 30%, but I still think about 10 to 20% of the economy is at serious risk of scarring. By scarring I mean, a degree of permanent damage, loss of capability, and so on.

The labour market has not been scarred. Due to the Jobs Support Scheme and the Jobs Growth Initiative, we’ve kept employment healthy. Not many people have been out of work for a long period of time. Corporates, by and large, because of the fiscal injections last year and continuing into this year, have largely stayed afloat. Last year, we did lots of scenarios internally of corporate collapses and their potential spillovers. But very few have materialised, so far. No doubt, there will be a few more corporate failures ahead, as the stimulus is fully withdrawn, but the financials of many corporates look reasonably resilient. So I think we can ride this through in terms of avoiding scarring of the general corporate sector.

But some industries, say the travel-related, are going to face some scarring. I think it’s already taking place. Take air travel, accommodation services, arts, entertainment and recreation – they have not recovered. The overall economy was back to pre-COVID levels in Q1. In Q2 and early part of Q3, it slipped again because of the renewed restrictions – Phase 2 Heightened Alert. Now we’re coming out of it, so I think by the end of the year the economy could be back to pre-COVID levels.

But a good 30% of the economy is still below pre-COVID levels. If that persists – and it will persist at least into 2022 – and the longer it persists, that’s when we get scarring. So I do worry about air transport. The consensus is that passenger traffic can come back to pre-COVID levels, at best, in 2024. So what’s going to happen till then? Now you can support the big airlines and the airports, but there’s a whole ecosystem of firms and activities built around them, which will be hard-pressed – how long can we keep them on life support when levels of activity are still only about 20-30% of pre-COVID? It’s a tough situation. I think there’ll be some shakeout in that ecosystem as a whole. What we need to make sure is our status as the air hub of the region remains, which is why the focus is strongly on Changi. We cannot lose that status. Likewise the airlines. But I think quite a number of the ancillary activities will get dented.

The same is happening in retail and F&B. There’s a structural change that has occurred because of the rise of e-commerce and online purchases. I will be hard-pressed to put a degree on the scarring, but there will almost certainly be some. It’s already happening.

Source: Monetary Authority of Singapore