Fed hikes rates

By GovernanceToday
In Economy
January 5, 2016
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 The first hike in about a decade signals a divergence between the US and other leading economies

fdihikeAfter a span of nine years, the US Fed has increased the interest rates in a move which has been coming a long time. The move marks the official end of the globally coordinated fiscal and monetary stimuli that was provided to the world economy that had come dangerously close to a halt in wake of financial crisis in 2008. The Fed announced a 25 basis point (0.25 per cent) hike in the Federal Funds Rate, the rate which forms the base of the overnight inter-bank lending market in the US. The Fed has also made clear market its intention to increase the rates in four tranches of a quarter percentage points each over next one year.

While the quantum of increase has not been high, it has received tremendous attention globally, in financial markets as well as in policy making circles. The reasons have been multiple, ranging from increasing divergence between the US Fed and other leading central banks to the possible impact on global trade and emerging markets’ economic health. Though the global equity markets have received the decision with cautious joy, actual impact would be seen over the course of coming weeks and months as money managers take a call on placing their bets in the coming year. In India too, opinions have varied on the possible impact of the move on economy and on financial markets.

Why now

The possible increase in interest rates had become a big betting game over last couple of years across the world financial markets. But gradually, markets had slowly accepted the inevitability of the rate hike over last year or so and in fact was hoping for a marginal hike in the second half of this year. This was because broadly, the consensus was developing in the US that the economy had strengthened to a level where it can withstand a hike even as other major economic blocks have not been doing that well. As such, the possibility of a shock from markets was perhaps the least running into the Fed Open Market Committee (FOMC) meet on December 16th. This was much in contrast to the situation in 2013, when the rate hike was mooted for the first time by officials, and had sent the global markets in a tizzy. So for a start, the fear of a negative reception was quite low.

Among other more substantive economic reasons, the unemployment situation could be named a major comforting factor for the Fed while deciding a hike. With joblessness at just 5 percent, Fed probably felt that the economy was strong enough to withstand modestly higher borrowing rates and an increasing rate regime. Another aspect of raising rates is the inflation connection. Fed has been targeting a 2 per cent inflation level which could be conducive to a growing economy. However, inflation is still lingering at half a per cent which makes it counter intuitive to raise rates. But the inflation has been low because of very low oil prices and if that starts to move up, inflation can shoot up fast which could have forced Fed to tighten rates too steeply, an imprudent move in a fragile recovery environment. As an equity analyst in Mumbai suggests, a gradual, multi step increase in small tranches is better option which is what Fed has settled for.

Impact on global economy

The global equity markets took the move in positive spirit as they felt the rise was not steep and had come with a clear indication on the future course of action, thus removing uncertainty on rate front for much of next year as well. But there are a few strands that need attention while understanding what global economy could face over coming months because of the Fed’s move.

There is a widespread belief that emerging-market countries and companies would feel the heat of increased cost of debt. Even though the impact of this rate hike is not very high, the cost of borrowing have been tightening for many months now. The expectation of increased rates has been driving down the currencies of most emerging markets which has been further abetted by the poor real economic health of these economies. Finally, and because of the above mentioned reasons, money have been flying out of emerging markets consistently; over a trillion dollars were pulled out of emerging markets in a year till July 2015. The flight to quality is likely to be accentuated post this rate hike as attractiveness of US assets would increase with further rates hikes over the course of next year.

Second flank of the problem is the increasing divergence between the stances of the US Fed which has signaled a tightening rate regime, and the stances of European Central Bank, Bank of Japan and Peoples Bank of China, each of which has been easing the cost and availability of money to prop up respective economies. This divergence, indicative of the relative difference in the economic health of the US on the one hand and other economic blocks on the other, could be a source of volatility of global financial markets more than the actual Dollar value of impact of increase in interest rates. These changes and impacts would take a few months to be reflected in countries trade and balance of payment statistics.

“There could be some outflow because expectations are that the rate of return in the American economy will be better…some capital will move out (of India)” C. Rangarajan, former RBI Governor

But there is a counter narrative to this argument according to which, moving forward, the real source of cheap capital would not be the US; it will be China which has been saving and investing a staggering rate but which is slowing down now and needs investments to be parked externally, for the very simple reason that its domestic market could not be absorb more investment right now, without pushing inflationary tendency. This could be a reason why it has been pumping so much money in building infrastructure abroad in recent years. The setting up of institutions like Asian Infrastructure Banks and BRICS Bank with massive Chinese contributions is another strand of this broad trend. The huge surplus of capital from China can hold down the impact on the increasing cost of long-term global capital that Fed tightening can unleash.

Is India isolated?

Amidst all the hullabaloo over the possible impact of the Fed’s decision on the world economy, the crucial question that is facing and would increasingly face Indian policymakers is how would the rate hike impact Indian economy and its corporates and financial markets?

As things stand, India is feeling doubly punched. First, it will feel the usual pain of emerging markets in form of rising cost of overseas debt and exit of money from financial markets. However, according to some analysts, ECB’s easy money policy could help India, like other emerging markets, cushion off the Fed’s tightening till the time government adjusts on a policy level. But broadly, the emerging markets have ceased to be the flavor of the season for global investors and India is not an exception.

At a broader economic level, India finds itself at a sticky ground. Its growth may be looking about all right, but individual segments are not looking bright. Industry is not reviving strongly and so is agriculture. Exports have also been hit badly over last few quarters. Many analysts are of opinion that the country could be seeing a stagnant period of corporate growth even as economy undergoes structural changes that the new government has been affecting. All of this means a period of uncertainty for corporate India.

They ask us not to spit on the roads. Aare sir, where will we spit then. We hardly get to eat the whole day and gutkha and paan are our only respite. They threaten to fine us but where do we spit? Arvind Subramanian, Chief Economic Advisor

Both of these factors mean that the country could feel the heat over a longish period as Fed affects more rate hikes and the relative attractions of American assets forces more investors to pull out of the country. Former RBI Governor C Rangarajan too feels that there could be an exit from India. In an interview to a news agency he said that “There could be some outflow because expectations are that the rate of return in the American economy will be better…some capital will move out (of India).” Another way it would hit India is that it would make external money dearer for massive infrastructure projects that India intends to put in place over the course of coming years.

But there are people who think that India is better suited to weather the rate hike season compared to other emerging economies. According to Chief Economic Advisor Arvind Subramanian, “As far as India is concerned, we are really well cushioned. Inflation is coming down, fiscal deficit situation is very good, external situation is also robust. So, I think for all these reasons impact on India would be very minimal.” He further added that “It is very difficult to be sure that this is going to be the beginning of a rate cycle, because it is clear from the Fed statement that they are going to be very cautious going forward.” The positive assessment has also been echoed by global rating major Fitch which said that while India is not immune to potential market jitters on account of interest rate hike by the US Fed, favorable economic growth outlook makes it attractive for foreign investors. It also said that the country’s lower dependence on exports and improved external balances make it better placed than many of its peers.

In totality, the rate hike decision of the Fed is a crucial development, if not in monetary terms, then definitely in psychological terms. On the one hand, it constitutes an important step in normalizing monetary policy that was pursued after the global financial crisis. But on the other, its impact on the global economy will be varied, unpredictable to an extent and most importantly, transformative in how global economic system functions. The emerging situation could be challenging yet one that could prove opportunities for India, should policy makers make right choices.