Fed Rate Hike: Decoding Impact on India and US

Playing on the plausible lines, the US Federal Reserve ultimately raised the rate of interest, in almost a decade in December. The Central Bank hiked interest rate by 0.25 basis points (bps). One basis point is one-hundredth of a percentage point. For market experts and economists, the latest move should transmit signals that further hikes are in wait, but all depends on how the global economy progresses forward from here.

Fed Rate Hike

Fed Rate Hike

Apart from the interest rate hike, Fed also raised projection for the economic growth next year believes despite rate hike the growth target will not be affected.

Interestingly, against the global expectation equity and foreign exchange markets in the emerging economies saw a bullish reaction to the hike. Till the point of action, it was widely assumed that the local bourses, especially in the emerging markets will see investors pulling out their investments eyeing the attractive US market.

However, it shouldn’t come up as a revelation since substantiation from the past 10 hikes shows that stock markets reacted positively, at least on 8 out of 10 occasions for almost all the countries under consideration.

The reaction from Indian stock market has always been against the pessimistic reactions. After one month of the past 10 Fed rate hikes, the average stock market increased by 6.7 percent and the exchange rate depreciated marginally against the dollar. The market experts are again keeping fingers crossed and believing that since the macroeconomic situation is robust at least in the case of India, the local markets will fare well.

From now on, as market experts believe, the further rate hike will be gradual and take around two-three year period for rates to reach 2 percent. It means that the cost of money will still be low and not expensive as is expected in many quarters.

Any further rate hike will depend on achieving a certain inflation level and is admitted by the Fed: “In determining the timing and size of future adjustments to the target range for the federal funds rate, the committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.”

However, none of the indicators other than unemployment rate have grown in the past few years. And even the inflation has come to a halt in the past 7 years despite carrying on three rounds of quantitative easing (QE).

Effect on US

The immediate impact of the Fed rate hike will be felt on the consumer credit. The pinch will be felt particularly in credit card and auto loan section. In the past seven years, the median income of the American household has shrunk by about 1 percent and credit growth has increased at the rate of 3.7 percent easily surpassing the growth in the US Gross Domestic Product (GDP).

Apprehensions are widely circulated in the global market that the recent hike in Fed rate encapsulates a partially defensive virtue. The section of experts believes that the latest move by the Central Bank is to counter the recession. If rates stayed at near zero any longer, the economy could have easily slipped into recession.

The economists suppose since the Fed is under deflation since 2008, it’s trying to avoid a zero-bound trap by the hiking the rates. It leaves an adequate margin to cut rates in the future which will help boost the economy in the coming days. In case the theory holds ground, the future may witness a few more rounds of the rate hike.

However, the ambition of rate hikes may face a dampener since building distress in the junk bond market in the US can paralyse the global financial system. The situation appears all the more gloomy since half of the junk bonds are exposed to the US oil sector and already the crude prices are touching an 11-year low.

Till now symmetric monetary policy was mainly influenced by sways in the market caused by expectations of a US rate hike. With the European Central Bank indicating a new round of QE as well as Bank of Japan and Bank of England not changing their policy stance, the discrepancy in monetary policy is now an actuality.

Effect on India

Amid all this, India should stand a solid chance to gain from the positive market volatility in the approaching days as it enjoys better macros.

Even before Fed came up with the hike, Reserve Bank of India (RBI) kept positively asserting in media that it is effectively prepared to face any kind of eventuality arising out of the rate hike. However, investors are unsure how much volatility will creep in as a result of the rate increase.

Nevertheless, this time, the RBI will not be forced to resort to forceful control measures for bond yields to drop such as those witnessed in 2013.

Back in 2013, the RBI restricted the ability of banks ability to take positions in the currency market in order to stall fall of the rupee against dollar and hold bond yields from rising. Bond yields shot up in July and the rupee depreciated to its lifetime low of 68.85 a dollar in August 2013.

However, this time, around the RBI wasn’t forced to intervene as in 2013. In fact, the day when Fed announced its decision to hike rate by 0.25 basis points (bps), stock markets in India bounced BSE’s 30-share Sensex rose 1.21 percent, or 309.41 points, to 25,803.78 points, while the National Stock Exchange (NSE)’s 50-share Nifty advanced 1.21 percent to 7,844.35 points. It was their biggest gain since November 19, 2015.

Also, NSE’s India VIX, or volatility index, which is a measure of near-term volatility in the market, dropped 15.02 percent, its steepest fall since 18 September, to 14.22, a level last seen on April 1, 2015 as traders heaved a sigh of relief that the ambiguity in the Fed’s course of action was over.

Likely impact

1) Foreign Portfolio Investments

• Equities

Equities form a substantial portion of foreign portfolio investments (FPIs) in India. There was an inflow of $1,641 million in October 2015 while outflow was recorded at $1,071 million in November 2015. An outflow of $724 million was recorded in the first half of December. It shows investors are cautious of the rate hike. Equity outflows are likely to moderate as the uncertainty of rate hike is eliminated and future movements would also depend on how the economy performs with corporate results holding the clue.

• Debt

Both the rise in US rate and the decline in key rate in India, FY 75 bps in FY16, may have a negative impact on the debt flows. In addition, the debt limits in have been almost used up in GSecs. Although, corporate debt window is open to foreign institutional investments (FIIs), there are limited funds flowing here.

2) Rupee Movement

The Indian Rupee is under the stress of forthcoming rate hike for sometime now. Just ahead of Federal Open Marketing Committee (FOMC) meeting, rupee reached a 2-year low level of Rs 67.10. The prime reason behind depreciation is high level of foreign capital outflow. The rupee will stabilise soon as net forex reserves are fairly stable.

3) Inflation

Due to an easing of commodity prices, especially falling oil import bill, the inflation has been in control. Increasing food inflation has been the main concern with a second consecutive season of deficient monsoon having a bearing on the crop output. The weakening of rupee against the Greenback as a result of the US rate hike may reflect in the inflation numbers for subsequent months as imports become dearer. However, the impact shouldn’t be significant since in net terms since rupee has held its position after the announcement of the rate hike.

Ashish Pandey

I am a business and finance journalist who is currently employed at Financial Express and previously at Zee News. My areas of interest include business and foreign policy. You can reach me on Twitter at @ashuvirgo1984 or @eFundsPlus.

You may also like...