Impact of rising US interest rates on global markets and India
It was December a year ago when the Federal Reserve announced increase in its benchmark interest rate, of 25 basis points for the first time in nearly a decade. After the year long wait, The Federal Reserve has increased its bench mark rates again by 25 basis points on this Dec 14th. Policymakers stated that the labor market has continued to strengthen and that economic activity has been expanding at a moderate pace since mid-year. Inflation is expected to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further. Compared to mere 25bps rise last year’s Fed projections suggested that rates would soar upward in 2016, to close to 1.5% by years’ end. The Fed has repeated that tradition as well; the projections published today repeat last year’s heroic call, of a rate near 1.5% one year hence.
Unlike last year, the next year would be different as many changes have taken place in the recent past – which would greatly affect the Fed’s future decisions. Wage growth and inflation in America are accelerating, for one. Yet the most momentous change is the election of Donald Trump as president. The prospect, under unified Republican government, of a big fiscal boost from tax cuts and higher spending, has sent both Treasury yields and the dollar on an upward gear.
The Fed’s hawkish tone has sent the dollar towards its highest level since 2002 against a basket of 16 peers. The WSJ Dollar Index is up 0.8% to 91.12, which would mark its highest closing value in over 14 years. It also affected market rates by pushing up two-year yields to their highest levels since 2009.
What are the implications of this rate hike for the rest of the world?
Higher rates have an impact on two variables which no country, including India, can escape. The first is the flow of investment. Higher rates in the US automatically mean that debt earns better rates back home and with the US being the biggest investor the flow to emerging markets will slow down.
It may be recollected that the QE programs of the Fed coupled with almost zero interest rates had caused investment to flow to emerging markets which were the faster growing ones. This was helped by the fact that growth was stronger in these countries. Now with growth prospects in the US being better, no support for QE which has been withdrawn and higher rates in the US to prevail, investment is bound to remain in the US with the possibility of reverse flow from developing countries also possible.
Second, higher rates is symptomatic of a strong country which, in turn, makes the currency stronger. Hence if the Fed keeps increasing rates the dollar will keep strengthening. This is so as higher rates get in more dollars thus improving the balance of payments. This, in turn, will make other currencies fall.
What does this mean for India?
First there will be pressure on FPI flows. Investment in equities will be driven by other factors. But those in debt will be under pressure. This is so as our rates are coming down at a time when Fed is increasing rates. This will widen the rate differential for investors. Add to this a weaker rupee and the outflows from debt will start. At best there would be no outflow but inflows will slow down sharply. Second is the issue of the rupee-dollar rate. The rupee will fall both because our fundamentals will weaken and that we have to keep up with the currency falls in other countries. The RBI will have a role to play here. In the past also we have seen similar challenges. Third the RBI interest rate policy, however, will not be affected much as it is being driven by inflation trends. Hence there will be no impact on its policy formulation.
Hence, the Fed rate hike should not be looked at as a single measure. This is the start if a series of rate hikes which can be punctuated only by Donald Trump’s ideas. The dollar will strengthen and investments flow will reverse and move back to the US. India cannot escape both these repercussions though interest rate policy will remain independent. Inflation can rise if rupee falls sharply, but overall growth should be insulated given that ours is a domestic oriented and driven economy.