The US Federal Reserve is on track to end quantitative easing by October. It began its unconventional monetary policy of buying bonds with newly created money in the immediate aftermath of the North Atlantic financial crisis. The US economy now seems to be on the path of recovery while the massive monetary expansion of the past six years has not sent inflation soaring.

But there are growing signs of a new round of irrational exuberance in the global financial system: a real estate bubble, soaring equity prices, lax lending standards, low implied volatility in financial assets and a compression of risk premiums.

The next stage of the normalization of US monetary policy will be higher interest rates. No one can predict when the cost of money will begin to inch up but the direction of interest rates is now quite clear. The moment of reckoning could be as early as the middle of 2015 even though Janet Yellen has indicated in her most recent statement that she is quite prepared to keep interest rates very low for some more time. Meanwhile, the struggling European and Japanese economies are likely to stay on their current course for much longer; the balance sheets of their respective central banks will continue to expand.

What are the risks for India? It must be remembered that India was one of the countries that suffered the most when the financial markets went into a tizzy after former Fed chairman Ben Bernanke first hinted in May 2013 that he would begin the tapering of quantitative easing.

India was a prime candidate for a panic run on the rupee thanks to its large fiscal deficit, current account vulnerability and high inflation. It is to the credit of former finance minister P. Chidambaram and Reserve Bank of India governor Raghuram Rajan that there is now greater commitment to fiscal discipline, the current account gap has been reduced and inflation has drifted down. One has only to compare our performance on these three variables over the past year to what has happened in the other fragile economies such as Turkey, South Africa, Brazil and Indonesia.

But that does not mean that India has no reason to worry. Its key economic indicators are still nothing to write home about. The overdue process of macroeconomic stabilization that began in August 2013 is not over yet. The recent decline in inflation will undoubtedly lead to a new clamour for lower interest rates. Cutting interest rates at a time when global interest rates rise will be a risky strategy as long as India has high inflation; the narrowing interest differential will likely put the rupee under pressure.

The International Monetary Fund has said in a new analysis on the potential spillover effects of higher global interest rates that a lot depends on the reason why monetary policy is being tightened in the rich economies. A real shock as interest rates rise in response to strong economic growth will be a positive since more robust economic activity will lift many boats. A money shock will be more of a problem as interest rates will go up faster than what is warranted in the real economy. The former will lead to positive spillover for countries such as India while the latter will lead to negative spillovers.

The relative calm in the financial markets since the emerging markets scare of 2013 has led many market participants as well as policy makers to lower their guard. It is hard to tell right now whether a new storm is brewing over the horizon, but it is quite likely that rising global interest rates will put a lot of the current buoyant assumptions about asset prices, risk premiums and currency values under severe test in the coming months.

Will an increase in US interest rates adversely impact Indian markets? Tell us at views@livemint.com

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