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Explained: Federal Reserve signals, and Indian markets

The US Federal Reserve has hinted at the possibility of two rate hikes by 2023, leading to a fall in market indices. While inflation is a concern in India, and it remains to be seen how the RBI responds, market participants are not too worried about inflation if it comes alongside an economic rebound.

The Federal Reserve building in Washington. (The New York Times: Ting Shen)

The Dow Jones Industrial index in the US fell 0.77% and treasury yields rose on Wednesday after the Federal Reserve indicated that there could be two rate hikes by 2023. In India, the benchmark Sensex fell marginally and the rupee lost over 1% against the dollar on Thursday. If the Fed changed its position in line with the progress in economic recovery and the inflation situation in the US, in India too there have been growing concerns on inflation.

The wholesale price index-based (WPI) inflation scaled a record high of 12.94% in May, pushed by higher fuel and commodity prices, and a low base effect. It also translated into retail inflation of 6.30% in May — a six-month high that breached the inflation target of 4 ± 2% set by the Reserve Bank of India. While it remains to be seen how the RBI responds, market participants feel that if inflation comes alongside a rebound in the economy, it should not be a big concern for investors.

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What did the Federal Reserve say?

While maintaining they would continue with an accommodative monetary policy and bond buying programme to support the economy, generate employment and achieve inflation of around 2%, Fed officials also discussed the rate hike and an eventual reduction, or tapering, of the central bank’s bond buying programme.

In a deviation from what it said in March, the Fed signalled that there could be at least two rate hikes by 2023 as economic activity indicators have strengthened and inflation has firmed up. Some members were also in favour of raising rates at least once in 2022. In March, the Fed signalled that they would hold the rates near zero through 2023.

In its statement on Wednesday, the Fed said it “is committed to using its full range of tools to support the U.S. economy in this challenging time… Progress on vaccinations has reduced the spread of Covid-19 in the United States. Amid this progress and strong policy support, indicators of economic activity and employment have strengthened.”

Chairman of the Federal Reserve Jerome Powell in Washington. (AP Photo/Susan Walsh, Pool, File)

How did the markets react?

A hike in interest rates in the US has a bearing on the debt and equity markets, not just in the US but also in emerging economies such as India that have witnessed record foreign portfolio investments (FPI) over the last one year.

After the Fed’s signalling, the Dow Jones Industrial fell 265 points and the treasury yield rose from 1.498% on Tuesday to 1.569% on Wednesday. In India, the benchmark Sensex fell 461 points or 0.87% during the day before recovering to close at 52,323 on Thursday, a decline of 0.34%. The rupee lost 75 paisa or 1% against the dollar on Thursday to close at 74.08.

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What could be the impact of an early hike in interest rates?

The Fed’s indication of a hike in interest rates earlier than expected resulted in a rise in bond yields and strengthening of the dollar. At the same time, it impacts currencies and stock markets in emerging economies.

News of a hike in interest rate in the US leads not only to an outflow of funds from equities into US treasury bonds, but also to an outflow of funds from emerging economies to the US. Experts say a rise in yields leads to a situation where they start competing with equities, and this impacts market movement. The rupee is also expected to come under pressure as the dollar strengthens.

But many feel that if the economic rebound is strong in the US and India, the impact of the interest rate hike in the US and some inflation may not be a big concern.

If the Fed’s stand in March provided relief and stability to the market as it gave them nearly two years’ time, the change in stance is expected to leave the markets a little watchful.

After June witnessed FPI inflows of Rs 14,500 crore into Indian capital markets, it remains to be seen if there is a slowdown in the pace of inflow over the coming weeks and months.

What are domestic inflation concerns?

Wholesale inflation has been rising for five months, and is expected to rise further as the impact of high crude prices and surging commodity prices feed in.

For a large number of commodities, their global prices are now getting reflected in their domestic prices. For instance, petrol, diesel and LPG witnessed inflation of 62.3%, 66.3% and 60.9%, respectively, in May 2021. The food inflation component for retail inflation rose significantly higher to 5.01% in May from 1.96% the preceding month. Some of the items that pushed retail inflation were fuel, which recorded inflation of 11.6% (the highest since March 2021), transport and communication at 12.6%, edible oil at 30.8% and pulses at 9.3%.

Is it expected to remain elevated, and what can the RBI do?

Rising global crude oil and commodity prices are expected to push up WPI inflation further in the coming months. With most developed countries opting for monetary stimulus measures, global commodity prices are rising amid expectations of a global economic recovery. In India, an ebbing of the second wave of the pandemic and increasing vaccination numbers have led to expectations of a recovery in demand, and higher raw material prices.

This would cause retail inflation to rise as well, putting the central bank on a tightrope walk in balancing the growth-inflation dynamics. While RBI is unlikely to change its accommodative stance or the policy rate anytime soon, it remains to be seen how it responds to developments around the world on interest rates. Meanwhile, as there is no further scope for a rate cut by RBI, all eyes are on the government for fiscal policy action to spur growth.

Should investors be concerned?

If global liquidity flow has boosted Indian markets over the last one year, experts say the rise in interest rates in the US and tapering of the monthly bond buying programme (currently $120 billion/month) may impact stock market movement. These factors, and rising inflation in the domestic market, will be key for equity market movement alongside the economic recovery and growth.

The recovery level of the Indian economy at the time RBI hikes rates rate — which may still be some time away — will be critical. The timing and pace of the US interest are hiked and tapering of the bond buying programme, too, will be critical for equity markets in India, which may witness an outflow of funds following the announcement.

If the Fed’s hawkish tone didn’t go well with the equity investors across the globe, the impact on Indian stock markets was not too pronounced. Pankaj Pandey, head of research at ICICIdirect.com, said that while interest rates will be raised in future, he doesn’t expect a knee-jerk reaction. “While inflation is going up, the underlying (factor) that is driving it is the economic rebound both in the US and in India. While the US will give advance warning before raising rates and tapering of the bond purchase programme, even in India RBI is looking to ignore inflation for some period of time. I do not see it as a big negative for the market if the economy is doing well,” said Pandey.

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