Financial Market

Impact of US Federal Reserve rate hike on Indian markets

United States consumer price inflation surged to a new 40-year high in June, up 9.1% year-over-year, according to data released on Wednesday (July 13) by the Bureau of Labor Statistics. The inflation print is way higher than the 8.8% forecast, according to American-British financial market data provider Refinitiv, with energy comprising nearly half of the monthly inflation surge.

Apart from the domestic impact, the latest US inflation print is likely to have a significant cascading impact across emerging market economies such as India, where sustained capital outflows from the capital market have unnerved stock markets and led to a weakening of the domestic currencies.

With the US Federal Reserve set to hike rates further, outflows from emerging markets are likely to continue, putting pressure on the currencies and markets.

What is the impact of a high inflation print?

The Fed looks out for core data when assessing inflationary trends, and the latest print is likely to prod the central bank to further intensify its aggressive series of rate hikes that began early this year. While the Fed is widely expected to raise its benchmark interest rate by at least 75 basis points at its next monetary policymaking meeting on July 26-27, the latest inflation print puts pressure on the American central bank to go even further.

According to Charlie Bilello, Founder and CEO of Compound Capital Advisors, after the Wednesday inflation release, “the market is now pricing in an 83% probability of a 100 bps hike at the FOMC meeting in 2 weeks, up from 0% a week ago”. The last time the Fed hiked rates by 100 bps in a single meeting was in 1981, incidentally the last time when inflation printed above 9% in the US before the latest June inflation data release.

The immediate impact was that the US dollar surged to a 20-year high against a basket of currencies, and the euro broke below parity against the US dollar. The euro plunged to $0.9998 against the greenback, breaking below the $1 level for the first time since December 2002, before bouncing back marginally on Wednesday, primarily in expectation of a sharper US Fed rate hike.

The Fed’s monetary policymaking meeting is expected to see a shifting of gears in its rate hiking action, coming on the back of a three quarters of a percentage point hike last month — its most aggressive move since 1994. The June hike, the third since March, came after inflation in the US surged unexpectedly in May.

The annual inflation rate in the US accelerated to 9.1% in June 2022, the highest since November of 1981 and above market forecasts of 8.8%. (Chart Source: Trading Economics)

More importantly, the US central bank could signal equally large hikes later this year, which could potentially dent the already wobbly investor outlook across markets.

What is the import of the Fed’s upcoming action to tackle runaway inflation?

While markets have largely factored in the reversal in the Fed’s policy stance, there are renewed concerns about the pace of the hike, given that the US central bank is now under renewed pressure to tame inflation as prices in the world’s largest economy surge. There are now clear indications that the Fed would be far more aggressive in its intensity of rate hikes, going by the guidance offered by Fed chair Jerome Powell.

Runaway inflation is being seen as a political headwind for US President Joe Biden ahead of the November midterm elections. Biden had said earlier this year that it was “appropriate” for Powell to adjust the Fed’s policies. And congressional Republicans, according to an AP report, have endorsed Powell’s plans to raise rates, providing the Fed with rare bipartisan support for tightening credit.

After Wednesday’s data release, Biden said the June CPI inflation reading was “unacceptably high” but asserted that it is “also out of date”, since fuel prices have dipped in the last 30 days. “Energy alone comprised nearly half of the monthly increase in inflation,” Biden said, according to a CNN report. “Today’s data does not reflect the full impact of nearly 30 days of decreases in gas prices that have reduced the price at the pump by about 40 cents since mid-June. Those savings are providing important breathing room for American families. And, other commodities like wheat have fallen sharply since this report.”

How does the upcoming Fed action to temper inflation impact global markets?

Traders across markets have been looking for signs since early this year that the Fed might be more aggressive about rolling back the stimulus that has been feeding stock market gains across geographies.

The new projections in response to the inflation trajectory are being seen as a definitive move to frontload the reversal of the central bank’s expansionary monetary policy put in place in early 2020 to invigorate the American economy amid the Covid-19 outbreak. Part of this support was in the form of an extraordinary bond buying programme, which was intended to bring down long-term interest rates and catalyse greater borrowing and spending by both consumers and businesses.

The Fed’s inflation-busting action comes amid criticism that the US central bank has fallen behind the curve on inflation. Powell and other Fed officials maintained till early this year that inflation in the US was merely a temporary problem related to supply chain issues. Prices have spiked since then, partly due to external factors that include the war in Ukraine and the continuing Covid-19 shutdowns in China’s key manufacturing hubs.

Why are the signals from the Fed important?

Like other central banks such as the Reserve Bank of India, as the US Fed conducts monetary policy, it influences employment and inflation primarily by using 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. Additionally, the bond-buying programme, also known as quantitative easing, was put in place in 2020 as an extraordinary measure to help the financial markets and the economy counter the impact of the pandemic.

This bond buying was an unconventional monetary policy tool (that was deployed during the global financial crisis as well), using which the central bank purchases longer-term securities from the open market in order to increase the money supply and incentivise lending and investment. Buying these securities augmented the supply of new money in the economy, and ended up dampening interest rates, while also expanding the central bank’s balance sheet.

The Fed has now halted the process of pumping the proceeds of an initial $15 billion of maturing Treasuries back into the American government debt market, effectively signalling the move to shrink its expanded $9 trillion balance sheet.

The Fed is not alone in its intention to hike rates. Last month, the Bank of England announced its fifth rate rise since December, pushing its benchmark rate above 1 per cent for the first time since 2009. Australia, Brazil and Canada too have also raised rates, while the European Central Bank has indicated that it could hike over the next couple of months.

In India, the RBI has carried out a cumulative hike of 130 basis points in the effective policy rate — the standing deposit facility rate and the repo rate hike of 90 bps — over the past three months (One basis point is one hundredth of a percentage point). While CPI inflation inched down marginally to 7.01% in June from 7.04% in May, it still marked the sixth consecutive month that the CPI data has breached the RBI’s upper band of 6%. the RBI is widely expected to increase the policy rate by up to 35 bps in its next meeting in August. Benchmark indices in India were up in opening trade on Thursday.

How do rate cycles work?

Interest rate hikes are the primary monetary policy tool used by central banks to tackle sporadic spurts in inflation. When interest rates go up in an economy, it becomes more expensive to borrow; so households are less inclined to buy goods and services, and businesses have a disincentive to borrow funds to expand, buy equipment or to invest in new projects.

A subsequent lowering of demand for goods and services ends up depressing wages and other costs, in turn bringing runaway inflation under control. Even though the linkages of monetary policy to inflation and employment are not direct or immediate, monetary policy is a key factor in tackling runaway prices.

Theoretically, a signal to hike policy rates in the US should be a negative for emerging market economies, especially from a debt market perspective.

Emerging economies such as India tend to have higher inflation and, therefore, higher interest rates than in developed countries. As a result, investors, including Foreign Portfolio Investors, tend to borrow in the US at lower interest rates in dollar terms, and invest that money in the bonds of countries such as India in rupee terms to earn a higher rate of interest.

What will be the impact of a more aggressive Fed rate action on other markets, including India?

A sharper-than-expected hike in rates in the US could have a three-pronged impact.

When the Fed raises its policy rates, the difference between the interest rates of the two countries narrows, thus making countries such as India less attractive for the currency carry trade.

A high rate signal by the Fed would also mean a lower impetus to growth in the US, which could be yet negative news for global growth, especially when China is reeling under the impact of a real estate crisis.

Higher returns in the US debt markets could also trigger a churn in emerging market equities, tempering foreign investor enthusiasm. There is also a potential impact on currency markets, stemming from outflows of funds.

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