Abheek Barua & Bidisha Ganguly: The impending rate hike

Why a hawkish Fed no longer bothers the market

Well, we have heard from the horse’s mouth now. Following a week of what appeared to be carefully coordinated statements from senior officials of the US central bank’s (the Fed) all powerful monetary policy committee that an immediate hike in the Fed’s policy rate is warranted, Fed Chairperson Janet Yellen made a surprisingly categorical statement on Friday at a public meeting in Chicago. “At our meeting later this month, the Federal Open Market Committee will evaluate whether employment and inflation are continuing to evolve in line with our expectations, in which case a further adjustment of the Federal funds rate would likely be appropriate,” she said. 

This might not sound quite so “categorical” to the lay reader but this is standard Fed-speak when it’s about to hike rates. The Fed meets on the 14th and 15th of this month and this means that the US Fed funds rate could move up by a quarter of a percentage point from its current range of 0.5 to 0.75 per cent. Until about a fortnight ago the markets were factoring in a hike only in June.

A decision to hike the rate in March instead of June could also imply that the central bank is interested in more frequent hikes. That means that instead of the two policy rate hikes that the markets were pencilling this year, the Fed could hike three times and accelerate the pace in 2018. 

The funny thing about this is that the markets took the change in the Fed’s stance in its stride. The US equity markets actually gained post Yellen’s speech and the dollar gained a tad but did not jump up sharply. The dollar’s stability mirrored the calmness in emerging markets (EM). The Indian stock market climbed up and the rupee gained. Clearly the fear that higher rates in the US would suck liquidity out and wreak havoc on non-dollar asset markets has dissipated. 

Why would this be? As a signal, a policy rate hike is read differently at different times. Earlier, when markets were almost entirely driven by cheap money created by programmes like quantitative easing (QE) by central banks without the support of underlying growth, markets panicked whenever they perceived a risk of rates moving up or the money machines slowing down. At the present moment, however, the Fed’s seeming rush to hike interest rates in the US is seen as validation of the fact that the US economy is on a steady wicket and it does seem to have a case. 

If one goes by the macroeconomic data prints of the last few months that seems to be indeed the case. A whole bunch of indicators ranging from manufacturing indices to retail sales to consumer confidence indicators have been strong. The February jobs report indicated a robust pace of hiring and a rise in wages, making a rate hike almost a certainty. And for the markets, this comes as a confirmation of the reflation story that is now a global theme.

Besides, the Fed also takes the global economic scenario into account when it arrives at a rate decision. Some market analysts see the Fed’s increased hawkishness as a sign that the worst of China’s woes are over and the risk of a sovereign crisis in Europe has diminished. Commodity prices including oil have rallied since the beginning of the year in recognition of better global growth prospects though they took a plunge recently with the prospect of a US rate hike. 

The big question is how long the rally in equity markets worldwide can continue in the face of successive rate hikes by the US Federal Reserve. Wall Street celebrated its eighth anniversary of a bull run earlier this week. Many now consider the US markets to be overvalued though opinions differ. Much would now depend upon Donald Trump’s ability to deliver on his promises of fiscal stimulus and deregulation and how long these take to implement. 

Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is chief economist, CII