New Delhi: The United States (US) Federal Reserve’s Open Market Committee (FOMC) wreaked global havoc Wednesday as it hiked its key policy rate — the Federal Funds Rate — by 75 basis points, taking it to 3-3.25 per cent in its quest to achieve “maximum employment” and a 2 per cent inflation rate over the longer run.
What triggered the global sell-off across financial assets was the Fed’s signal that it would be more aggressive in its rate hikes, with the policy rate to rise to 4.4 per cent by the end of 2022 and peak at 4.6 per cent by the end of 2023 — something that players in the financial markets had not anticipated.
One basis point is one-hundredth of a per cent.
Following this, all asset classes — bonds, stocks, and currencies — declined. This means that central banks across major economies, including India, will have to recalibrate their actions accordingly.
Back home, while the equity markets did not react too negatively to the Fed rate hike, the rupee crossed the 80-to-a-dollar mark, closing at 80.86 as fears of capital outflows emerged, with the interest rate differential in the bond yields narrowing between India and the US.
According to Jigar Trivedi, senior research analyst, commodities and currencies at Reliance Securities, it seems that for the fourth straight month, the greenback (dollar) will end with a huge gain, all thanks to the Fed. Except for May, the greenback has stayed buoyant throughout 2022.
Against this backdrop, ThePrint assesses how the actions by central banks globally and factors such as rising inflation and movement in currencies impact India’s macroeconomic indicators. But before we delve deep into the analysis, it’s important to take stock of events in the global markets that may impact India’s macro fundamentals.
Global markets round up
High inflation rates across major economies have ensured that central banks increase interest rates while managing the pressure on their currencies emanating from the expectation of large capital flows to the US from emerging markets.
Despite the Fed’s rate hike, Japan’s central bank — the Bank of Japan — decided to keep its interest rates negative, resulting in a sharp decline of the yen. As a result, the central bank had to intervene in the currency market to support the yen for the first time since 1998 to stem a 20 per cent fall against the dollar this year.
Japan’s core consumer inflation reached 2.8 per cent in August, hitting its fastest annual pace in nearly eight years and exceeding the central bank’s 2 per cent inflation target for a fifth straight month.
The inflation rates in the US and the UK remained elevated at 8.3 per cent and 9.9 per cent respectively in August, which triggered the Fed’s latest rate action. The Bank of England has also increased its key policy rates by 50 basis points to 2.25 per cent — the biggest rate rise since 1989.
The Eurozone, too, is reeling under the pressure of a high inflation rate of 9.1 per cent — the highest since 1999, when the euro was officially issued.
Earlier this week, the chief of the European Central Bank (ECB), Christine Lagarde, said the ECB may need to raise interest rates to a level that restricts economic growth to combat inflation.
Following this, the Swiss National Bank hiked interest rates by 75 basis points to bring borrowing costs above zero for the first time in eight years, while Norway’s central bank raised its key interest rate by 50 basis points.
Impact on India’s macros
The first direct impact of the Fed’s aggressive rate hikes is likely to be on India’s monetary policy. In order to limit capital outflows, market experts now expect the Reserve Bank of India (RBI) to hike the key policy rate — the repo or repurchase rate — by 50 basis points to 5.9 per cent on 30 September, when the RBI releases its monetary policy resolution.
The repo rate is the rate at which commercial banks borrow from the RBI.
Pankaj Pathak, fund manager-fixed income, Quantum Mutual Fund, said: “With this level of hawkishness from the Fed, it would be extremely difficult for the RBI to soften its tone on domestic monetary policy anytime soon. India doesn’t have that much of an inflation problem, but our external balances are not in the best shape”.
India’s retail inflation rate in August was 7.0 per cent — higher than 6.7 per cent in July — remaining above the upper end of the RBI’s inflation target of 2-6 per cent since January. The RBI expects the inflation rate in India to average 6.7 per cent in 2022-23.
This second will be the pressure on the rupee, because as interest rates rise in the US, this will wean away foreign investors from the Indian markets and push them to park their money in less risky assets like the US dollar.
The rupee breached the psychological mark of Rs 80 to a dollar after the Fed’s rate hike, but investors believe more pain is yet to come with US Fed’s aggressive rate hike.
“Going ahead, the dollar index on the charts has formed a strong base near 110 and if this level is sustained…there could be another leg of a rally to 113 levels. In that scenario, the USD-INR has all the potential to go above 81, amid the escalation of a geo-political risk between Russia and Ukraine. To add to the pain, in case the energy cost goes higher, the rupee may continue to slide,” Trivedi said.
The dollar index, which hit a new 20-year high at 111.80 Thursday, represents the value of the dollar against a basket of six major currencies — Euro, Japanese yen, Canadian dollar, British pound, Swedish krona, and Swiss franc.
Anitha Rangan, an economist at the financial services provider Equirus Group, said that with the government borrowing calendar (a schedule for the auction of government securities) likely to have a higher supply of government bonds, “The RBI may be balanced in the rate approach, but defending currency (volatility) with reserves may not be enough when the Fed is expected to hike more than anticipated.”
While a depreciating rupee is good for India’s exports, it will have a negative impact on the current account deficit — that is, when imports of goods and services of a country are more than its exports. With India importing 80 per cent of its oil needs, the current account deficit is likely to bloat to around 3 per cent of the GDP.
India recorded a current account deficit of 1.2 per cent of GDP in 2021-22 as against a surplus of 0.9 per cent in 2020-21 as the trade deficit widened to $189.5 billion from $102.2 billion a year ago.
India’s trade deficit in the first five months of the current financial year 2022-23 has increased 592.6 per cent to $79 billion compared to the same period last year.
In the event of large capital outflows and a burgeoning trade deficit, the RBI will be forced to dip into its foreign exchange reserves to finance the current account balance.
RBI data released Friday showed that it has sold a net of $38.8 billion from its reserves between January and July this year to curtail rupee volatility. The reserves have fallen to a two-year low of $550 billion from a peak of $642 billion in October 2021.
(Edited by Uttara Ramaswamy)