Stocks and bonds rallied after the US Federal Reserve raised interest rates on Wednesday. This is in contrast to 2013, when just a hint that the US central bank would start reducing the quantum of its asset purchase sent financial markets all over the world into a tailspin.
The Fed’s latest decision to raise rates was perfectly coordinated as markets, until just a few weeks ago, were not expecting the central bank to act in March. But members of the rate-setting committee, including Fed chairperson Janet Yellen, clearly indicated in their recent public appearances that the US central bank was on course to raise rates in March itself. However, the Federal Open Market Committee did not change its projection for future rate hikes for the year, which means that there will be two more hikes during the year.
Since the Fed has not accounted for the implication of President Donald Trump’s expansionary fiscal policy at a time when the labour market is tightening, it is possible that the US central bank will actually end up raising rates faster than is currently anticipated. The market impact of any change in the pace of normalization will depend on its timing and the Fed’s communication.
At a broader level, by raising rates sooner than most market participants expected until recently, the Fed has taken another step towards normalizing policy and ending the unprecedented era of easy money—though the process is likely to be long drawn. Remember, the Fed also needs to reduce the size of its balance sheet. The Fed balance sheet has expanded from about $900 billion before the financial crisis to the current level of about $4.5 trillion. It is likely that the Fed will start shrinking its balance sheet after the process of normalizing interest rates is complete—or at least is in an advanced stage—as has also been suggested by the former chairman of the Fed, Ben Bernanke. In a blog post in January, Bernanke noted: “…the effects of initiating a reduction in the Fed’s balance sheet are uncertain. Accordingly, it would be prudent not to initiate that process until the short-term interest rate is safely away from the effective lower bound.” Since the shrinking of the balance sheet will result in tightening of financial conditions, it will remain a risk for financial markets.
The forward movement by the Fed in normalizing the monetary policy will result in policy diversion in the developed world as other systemically important central banks like the European Central Bank (ECB) and the Bank of Japan (BoJ) continue to pursue the unconventional policies of negative rates and quantitative easing. But conditions in the global financial system should be expected to tighten in the short to medium term as US monetary policy has a much greater impact on the global financial markets.
It is also likely that from here on, both the ECB and the BoJ will at least refrain from expanding their ongoing quantitative easing programmes. The ECB in its statement last week, for instance, indicated that the economic outlook is improving and there is no urgency to take further action. The BoJ on Thursday decided to leave the policy unchanged.
As US monetary policy returns to normalcy, the global financial system will also have to make the necessary adjustments. In the aftermath of the financial crisis, the availability of cheap dollar funding resulted in higher foreign borrowing in several economies. A 2016 note by the Bank for International Settlements, for example, showed that at the end of 2015, out of the total $9.7 trillion worth of dollar debt outside the US, one-third was held by entities in emerging market economies. Rising rates and the strengthening of the dollar could pose challenges for companies and financial markets in emerging market economies. In this context, China remains a risk. Capital is flowing out of China and it has lost about $1 trillion worth of reserves in the last few years in defending the renminbi. Following the Fed, the People’s Bank of China has raised short-term rates—which highlights the problem in the currency market.
However, India, with its stable macroeconomic fundamentals and modest current account deficit, is better placed to deal with the Fed’s policy normalization.
While forward movement in the direction of policy normalization is a welcome development as it indicates improving economic fundamentals in the world’s largest economy, commensurate adjustment in the global financial system will be a key risk to watch out for.
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