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Inflation captivated the world's attention in the second half of 2021, and the first half of the new year is all set to fight the inflation battle.

Last month in December 2021, Federal Reserve policymakers moved into inflation-fighting mode. They said they would cut back faster on their pandemic-era stimulus at a time of rising prices and strong economic growth. This caps a challenging year with a policy shift that could usher in higher interest rates in 2022.

US consumer prices soared last year the most in nearly four decades, illustrating red-hot inflation that sets the stage for the start of Federal Reserve interest-rate hikes as soon as March.

To help you understand how the Covid-19 outbreak influenced global inflation, we spoke with Arvind Chari, Chief Investment Officer (CIO) at Quantum Advisors.

In this interview, he shares his view on how the impact of rising interest rates and inflation may affect India and other emerging markets.

Read on for a very insightful interview:

Equitymaster - US inflation is at its highest rate in nearly four decades, reaching 6.8% in November 2021. What, in your opinion, is the root of this, and why are consumers seeing price increases for a range of goods and services?

Arvind - The rise in consumer price inflation is not only a US phenomenon. The OECD CPI inflation rate for November was also around 6%. Of course, US is seeing the largest increase among developed nations.

The initial explanation was that Covid caused supply chain disruptions which led to a supply side pressure. Thus led to higher input prices, which is now leading to higher consumer prices.

Also, in the pandemic, consumers spent more on goods, as services sectors like hospitality, travel, restaurants, entertainment were restricted, thus causing goods inflation. There were certain sectors which were causing a spike.

We hoped that as it normalises, the overall inflation would trend down. That hasn’t happened.

As we now know, levels of current consumer price index (CPI) inflation are much higher than what was forecasted a year back. A tight labor market and firms trying to recoup lost earnings, has meant that even services inflation has picked up.

Our sense has been that given the unprecedented fiscal response by the US government, a large part of the current inflation was also demand driven. Paycheck payments by the government and higher savings at households has meant higher disposable income. Thus higher demand for goods and services leading to a sustained price rise.

Equitymaster - Is rising inflation just a temporary blip or is it here to stay? What are your thoughts on this?

Arvind - The current elevated levels might not sustain. We will see year on year (YoY) numbers trending down as base effect catches on over in 2022.

However, the level of average inflation will likely remain above the pre-pandemic levels. The US economy is almost at full employment. Many sectors are facing labour shortage.

We have seen increases in not only in minimum wages but also in the hourly earnings rate in the private sector. American households have also seen a significant wealth effect.

US house prices have increased at a record pace allowing homeowners to leverage against property for consumption. Equity markets are close to record peaks. The overall global economy has done well and seems to be in a virtuous demand and capital expenditure (capex) upcycle.

All this suggests to us there are multiple demand and supply drivers for inflation and it is likely to remain above its last 10 years historical average.

Equitymaster - It is expected that the Federal Reserve (Fed) will start raising interest rates as early as March 2022. How many rate hikes do you see this year? And your view on the pivotal 10-year US T-Bond?

Arvind - I have always felt that US policy markers lean on the conservative side. They seem very sensitive to high inflation eroding purchasing power.

In the light of the facts above, there is no doubt that the US Fed will prioritise inflation over growth. In fact, they will be prepared to sacrifice a bit of growth and employment to get inflation back down towards its 2% target.

The rate hikes this year are essentially a move towards normalisation. The US economy no longer requires the ultra accommodative support of bond buying (QE) and low rates. Hence, we see the US Fed hiking by 3 if not 4 times this year.

We would expect the rate hikes to continue in 2023 to take the US Fed funds towards the 2% level from the current level of 0%-0.25%.

The US 10-year bond yield will be more sensitive to how the US Fed deals with the issue of stopping its bond purchases and eventually allowing its balance sheet to shrink.

We will not be surprised to see the US 10-year yield trade above the 2% level if the Fed begins its balance sheet reduction this year.

Equitymaster - Will the economy suffer as a result of higher interest rates? What impact will it have on emerging markets throughout the world?

Arvind - Emerging markets, after a long time are seeing a period of global growth recovery. Globally, governments are prepared to keep fiscal deficits high and maintain the growth level. This bodes well.

A cycle of higher growth with reasonable inflation is actually good for emerging markets.

Emerging markets (EMs), given their economic slack, are also seeing lower inflation pressures than the developed world. At the economy level, emerging markets should be able to sustain slightly higher interest rates.

At the markets and asset prices level, we should expect volatility. So much of the flows and valuation in EM assets across, equity, private equity, venture capital, and fixed income is dependent on the perception and level of US interest rates and of the US dollar. As Fed hikes and takes out liquidity, valuation of many EM assets will come under question.

Equitymaster - In particular, how do you see the impact of higher US interest rates play out in India?

Arvind - As with other EMs, Indian asset markets won’t be immune to a hawkish US Fed. However, we are in a better position than 2013, where India was tagged as part of the ‘fragile five’.

The key short-term risk remains oil prices. As oil inches towards US$100 per barrel, we would see short term macro concerns of higher bond yields and weaker Indian rupee (INR). It will force RBI to hike aggressively.

In fact, we will argue that even now India also does not need ultra accommodative policy and the RBI should begin its normalisation of rate hikes and liquidity withdrawal.

India, overall is in a better position to deal with higher global interest rates.

In our recent note, we postulated that India is on the cusp of a sustained economic revival.

Multiple tailwinds from improving corporate and bank balance sheets, recovery in residential real estate, a boost from global trade and exports and the availability of global capital, suggests to us that with some luck and sane policy making, India’s gross domestic product (GDP) growth can recover and grow at a faster pace than pre-pandemic.

India has grown at 6%-6.5% GDP growth with inflation above 5%, repo rate above 6% and 10-year bond yield above 7%. That’s our 20-year average. So, we don’t see why that should not hold true today as well.

Happy Investing!

(This article is syndicated from Equitymaster.com)

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