Hawkish Fed

Going forward, the US fiscal policy holds the key

The US Federal Reserve’s decision to increase interest rates by a quarter point was expected, but the accompanying statement that signals a faster pace of increases in 2017 is being interpreted as hawkish. The statement suggests that the Fed is prepared to raise rates three times in 2017; and the market was, at worst, hoping for not more than two hikes. The Fed did not change gross domestic product growth expectation much; it still sees the US economy growing at around two per cent over the next three years. But inflation is rising and the central bank expects its target of two per cent retail inflation to be hit soon. The expectation of higher inflation may have been fuelled by policy changes signalled by the incoming administration of Donald Trump. “There is considerable uncertainty about how economic policies may change, and what effect they will have on the economy,” said Janet Yellen, the Fed’s chairperson. Mr Trump has promised large-scale infrastructure spending alongside protectionist policies and tax cuts. Globally, the Fed action and its strong statement has boosted the dollar, which has gained against every currency. The yields of dollar-denominated bonds and US Treasuries have risen and dollar-denominated prices of gold and crude have dropped. Most stock markets have reacted negatively. 

Capital is expected to flow out of high-risk emerging markets and the slow-growth Euro zone into the US bond market. Indeed, there has been a pattern to foreign portfolio investors (FPIs) selling rupee assets for several months. The FPIs have divested over Rs 57,000 crore since October, with net sales of Rs 45,201 crore in debt and Rs 22,609 crore in equity. The selling could intensify given the Fed’s hawkishness. Protectionist policies in the US will not only lead to higher US inflation — because US wages are higher — but also result in lower goods exports from emerging markets. Policy changes could also affect the information technology industry, which is apprehensive that work visa quotas may be tightened. The rupee is already trading close to historic lows against the dollar, in part due to the reversal of roughly $28 billion of foreign currency non-resident swaps, which have reportedly been completed; however, the heavy selling by FPIs has also contributed to the pressure on the rupee. 

Expectations that the Reserve Bank of India would cut rates in December have been belied, but the latest consumer price index-based inflation readings show a record low for November and the central bank is expected to maintain an accommodative stance and probably will cut rates soon. Economy-watchers are expecting that fiscal policy will also be eased in the 2017-18 Budget in order to kick-start a stalled economy post-demonetisation. The narrowing of cross-currency yields that will result because rupee rates are falling and dollar rates rising could lead to the rupee depreciating. Indeed, one respected financial advisory is targeting a rate of Rs 70.5 to a dollar by end-2017. A lower rupee might trigger further capital flight by FPIs and lead to caution among direct investors but there is a flip side as well: A weaker rupee will stimulate exports, although rising protectionism could play spoilsport. In fact, what the Fed statement signals is that it is no longer about monetary policy. The Indian economy must be prepared for disruptive, and potentially damaging, changes in US fiscal policy rather than expect the continuity it enjoyed during the Barack Obama era.