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Fed is turning hawkish; should we worry?

REUTERSPremium
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  • The US Federal Reserve has decided to speed up its taper timeline, an outcome of higher inflation, expanding economic activity and a stronger labour market. Mint explores the potential impact on the Indian economy.

What did the Federal Reserve decide?

In response to the coronavirus pandemic, the Fed had been buying $120 billion worth of  bonds —$80 billion in Treasuries and $40 billion mortgage-backed securities every month. In its  mid-December meeting, the  US central bank said it would double the reduction of its monthly asset purchases to $30 billion, thereby concluding the tapering programme by March 2022 as against the previous timeline of mid-2022. Also, the vote was in favour of at least one interest rate increase in 2022 as against the September 2021 decision not to hike interest rate till 2023.

Why did the Fed speed up the taper timeline?

Supply chain disruptions and increasing consumer demand led to US inflation levels spiking to 6.8% (the highest in three decades) in November 2021, thus putting pressure on the Fed to increase interest rates sooner than  planned. Expanding economic activity has also resulted in improved labour market conditions. With the US  economy picking up substantially and retail prices going up dramatically, the Fed’s dilemma  is the same as that of the Reserve Bank of India (RBI): they are caught between rising inflationary trends and the need to revive the economy.

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What could be the impact on the Indian economy?

Rising US interest rates would result in US financial markets being a more attractive investment option, leading to net foreign investment outflows from India and rupee depreciation. However, with foreign exchange reserves at $635.8 billion as of 10 December, RBI has been consistently stating that the Indian economy is better prepared to absorb external shocks.

 

What is the recent trend in FII flows?

Foreign institutional investors (FIIs) have been net sellers since October.December could be the third straight month of FII outflows. In October and November, foreign portfolio investors (FPIs) offloaded Indian securities to the tune of $1.8 billion and $790 million, respectively. As of mid-December, India had seen FPI net equity investments outflow of $1.7 billion. After the Fed move, Indian capital markets ended marginally higher on Thursday. However, on Friday, the Sensex slipped 1.54% and the Nifty fell 1.53%.

 

What are some of the warning signs?

The move could lead to a decline or correction in Indian capital markets. A weakened rupee would result in increased landed price of crude oil leading to higher supply side inflation. Though retail inflation has been well within the band of 4% (+/-) 2% at 4.91% in November, core inflation was at a high of 6.08%. Higher crude oil prices will only worsen the situation and might put pressure on RBI to re-think its stance and raise rates faster than anticipated. Jagadish Shettigar and Pooja Misra are faculty members at BIMTECH.

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