The positive side of Fed rate hike
4 min read 22 Dec 2015, 11:08 PM ISTIt is unlikely to hurt stock markets, and based on past evidence, India will do well out of any resultant volatility
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As anticipated, the US Federal Reserve raised interest rates for the first time in almost a decade, signalling that the pace of subsequent hikes will be gradual and will depend on how the economy moves forward. The central bank also raised its projection for economic growth next year from 2.3% to 2.4%, which suggests it does not think that the rate increase will affect growth. However, the Fed rate hike settles one issue—that asymmetric monetary policy across developed economies is now a hard reality.
At first glance, it is perceived that the 25 basis points (bps) hike by the Fed will widely impact stock and foreign exchange markets. One basis point is one-hundredth of a percentage point. However, evidence from the past 10 rate hikes shows stock markets reacted positively, at least on eight out of 10 occasions, for almost all the countries under consideration. It should also be noted that during this period, equity markets saw a bullish phase. Increasing risk appetite among global investors made them flock to emerging markets. It was only on two occasions that the stock markets reacted negatively.
In the case of India, the average stock market increase was 6.7%, while the exchange rate depreciated marginally against the dollar, after one month of the past 10 Fed rate hikes. There is hope this time as well that Indian markets will react positively as the current macroeconomic situation is robust enough to propel confidence among investors.
In my view, a 25 bps increase does not change the world. So, from zero, if the Fed moves to 25 bps and the European Central Bank rates are effectively (-) 30 bps, essentially we are still in a world of free money. It is not that money will suddenly become expensive. The Fed’s increases will be gradual and, if over a two-three year period, rates move to 2%, it will still mean low-cost money.
The current Fed rate hike is based on its assessment of the US economy vis-à-vis its position in 2008 (see table). Apart from the unemployment rate, none of the indicators have grown as one would have expected before the rate hike. Importantly, inflation has not picked up and has instead come to a halt in the past seven years despite three rounds of quantitative easing (QE). Hence, any further rate hike will depend on achieving this goalpost and is admitted by the Fed: “In determining the timing and size of future adjustments to the target range for the federal funds rate, the committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2% inflation."
For the US, the immediate impact of the Fed rate hike will be felt on consumer credit, particularly credit cards and auto loans. Since 2008, consumer credit has increased at a rate of 3.7% per year, greater than the growth in US gross domestic product. The median income of the household has contracted by around 1% in the past seven years.
An important undertone in the Fed’s statement was that the rate hike was partially defensive. If rates stayed at near zero, the Fed might not have the tools to combat a recession. Thus, the Fed is confronted with the dreaded question whether deflation leads to recession. Since the US economy has now been deflating for seven years, it appears that the Fed is trying to avoid the zero-bound trap by raising the rates now, thus leaving enough room for a rate cut in the future, which will help manage the economy. It is from this vantage point alone that one can perceive a few rounds of rate hike. But emerging distress in the junk bond market in the US can spread to other parts of the financial system and can limit this ambition of rate hikes. Half of the junk bonds have exposure to the US oil sector at a time when prices have touched an 11-year low.
In terms of the wider significance of the event, the move appears largely symbolic. Till 15 December, asymmetric monetary policy was mainly influenced by swings of markets’ expectations of a US rate hike. With the European Central Bank indicating a new round of QE as well as Bank of Japan and Bank of England not changing their policy stance, divergence in monetary policy is now a reality. Any cry for joint response is a thing of the past.
In the end, the rate of growth of MSCI Emerging Markets Index, which captures trends in large and mid-cap companies across 23 emerging markets, has increased over the years, exhibiting better prospects. However, this has been accompanied by increased dispersion in emerging market returns, indicating higher uncertainty in the global financial system. The hope is that India with its better macros stands to gain from positive market volatility in the coming days.
Soumya Kanti Ghosh is chief economic advisor, State Bank of India. These are his personal views.
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