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The US Federal Reserve is set to lower borrowing costs at the conclusion of its two-day meeting later today, marking the third consecutive rate cut in its benchmark federal funds rate.
While that is as per script, analysts are gearing up for what they’re calling a “hawkish cut” to be delivered Wednesday, alongside interest rate outlooks and economic forecasts covering the first months of the incoming Trump administration.
Analysts will be keenly tracking the projections and remarks that Fed Chair Jerome Powell will deliver in a post-meeting press conference later in the day to discern if policymakers are turning more cautious about further rate reductions. That is what seems to be making markets nervous.
Market slide
In India, domestic stock markets on Tuesday plunged 1.30 per cent ahead of the Fed’s decision on rates, and slipped further nearly 0.7 per cent on Wednesday amid capital outflows by foreign portfolio investors (FPIs), primarily on the back of rising US bond yields and a strengthening dollar.
Analysts said that while markets have already discounted a 25 basis points rate cut (one basis point being one-hundredth of a percentage point), the focus will be on the Fed chief’s commentary and any departure from the dovish tone could be seen as a negative from the market perspective.
Policy decision announcements from the Bank of Japan and the Bank of England are also on the cards in the coming days. The rupee had depreciated to a new low of 84.93 to a dollar on Tuesday and closed flat at 84.90.
So, while there is little doubt that the Fed is widely expected to cut by 25 basis points, the concern roiling the markets is the possibility of a signal that the American central bank is moving to a more gradual pace of rate reductions on a go-forward basis. According to former Boston Fed President Eric S. Rosengren, there are worries that the incoming administration in Washington could veer in favour of lower taxes, curbing immigration and high tariffs. These moves by the new dispensation will make it more difficult for the Fed to reach its 2 per cent inflation target.
Analysts have been predicting that borrowing costs in the US will fall further in the months ahead, but have warned that Trump’s impending tax cuts plans, tariff hike proposals and immigration control measures could stoke inflation and drive up government borrowing, thereby potentially driving a conflict with the American central bank. Interest rates on US debt have already been surging, reflecting those concerns.
The Trump presidency is being viewed as positive for American stocks, good for the dollar, but somewhat negative for treasuries with a risk of fiscal profligacy.
For India, the Trump presidency could mean a challenge towards balancing its growth ambitions amid disruptions to supply chains, trade wars and tariff barriers and heightened forex volatility. Delayed cuts by the Fed would also impact the trajectory of the Indian monetary policy as the Reserve Bank of India may first try to resolve the uncertainties before undertaking any significant rate cut action.
The Fed (and other central banks) influences employment and inflation primarily by using monetary policy tools to control the availability and cost of credit in the economy. The Fed’s primary tool of monetary policy is the federal funds rate, changes in which influence other interest rates — which in turn influence borrowing costs for households and businesses, as well as broader financial conditions.
When interest rates go down, it becomes cheaper to borrow — so, households are more inclined to buy more goods and services, and businesses have an incentive to borrow funds to expand operations, buy equipment, or invest in new projects.
Improved demand for goods and services pushes up wages, and helps rekindle the growth cycle. While monetary policy does not link directly or immediately to inflation and employment, monetary policy is a key factor in curbing runaway prices or stoking the growth impetus.
A cut in interest rates in the US could have a three-pronged impact.
*The difference between the US and other countries’ rates could widen — making countries such as India more attractive for currency carry trade. The lower the US rate, the higher the arbitrage opportunity, till the time that the rate-cut cycle starts in other economies as well.
*A lower rate signal by the Fed would also mean a higher impetus to growth in the US, which could be positive news for global growth, especially as China reels due to a real estate crisis and shows signs of slowing down.
*Lower returns in US debt markets could also trigger a churn in emerging market equities, improving foreign investor enthusiasm. There is also a potential impact on currency markets, stemming from inflows of funds.
A faster winding up of the Fed’s rate cut action has implications for most countries. The RBI last cut the repo rate by 40 basis points to 4 per cent in May 2020, when the Covid-19 pandemic led to a slowdown in demand, production cuts, and job losses. RBI has since hiked the repo rate by 250 basis points to 6.5 per cent in order to tackle runaway inflation (it has a mandate to keep inflation at 4 per cent, with a cushion of 2 per cent on either side).
At its last meeting, the RBI’s Monetary Policy Committee on December 4-6 held the benchmark lending rate (repo) while cutting the cash reserve ratio (percentage of a bank’s total deposits that it must keep with the RBI as liquid reserves) to ease liquidity.
BoJ hike
The other major external reason that could influence Indian markets is the expectations of a rate hike by the Bank of Japan, which may impact the yen carry-trade equation (carry trade involves investors using a high-yielding currency to fund a transaction involving a low-yielding currency).
In August this year, when the BoJ raised rates to 0.25 per cent from 0.1 per cent, it resulted in unwinding of yen carry trade positions, leading to a crash in the Sensex and the Nifty. The Bank of Japan is expected to hike rates at its December meeting (18-19) as it is slated to consider uncertainties surrounding the new administration in the US. Given the weakening of the yen over the past couple of months, the BoJ is likely to hike rates.
