What Does the Fed Rate Hike Mean for the Indian Economy?

The Fed decision on rates announced on 14th December was largely in line with analyst expectations. After a gap of 1 full year, the Fed again hiked the Fed rate by 25 basis points. With this 25 bps hike in the Fed rate, the range stands enhanced to 0.50%-0.75%. It may be recollected that back in 2009, in the aftermath of the Lehman crisis, the Fed had cut the Fed rate to the range of 0%-0.25%. It had maintained the rates in that range till late 2015. For the first time in 7 years, the Fed rate was enhanced by 25 bps in December 2015 to a range of 0.25%-0.50%. The current rate hike comes a full year after the previous rate hike in December 2015.

Key drivers for the rate hike decision…

• Employment and increase in wages
• Economic growth and consumer demand
• Rate of inflation

The US economy has been sustaining an unemployment level of around 4.6%-4.9% for quite a few months now. According to the accepted definition, any level of unemployment below 5% is treated as tantamount to full employment. Since full employment is one of the conditions for a rate hike, that is surely taken care of. The rate of growth in wages is still stagnant, but is likely to grow as a function of growth. In terms of growth and consumer demand, while the initial green-shoots are visible, the actual growth is yet to manifest itself. However, the Fed believes that the sharp tax cuts proposed by Donald Trump and his proposed investment of $1 trillion in infrastructure could have multiplier impact on growth, consumer demand and wages. Finally, there is the aspect of inflation, which is still below the Fed mandated 2% to justify a rate hike. But in previous minutes the Fed has underscored that if the outliers in the form of low oil prices are removed and future growth is factored in, then effective inflation could be getting closer to the 2% mark. The case for a rate hike in the December Fed meet, therefore, was quite strong and set the tone for the 25 bps hike.

Stance of the rates trajectory…

There has been an interesting shift as far as the trajectory of rates is concerned. Prior to the December Fed meet, the indication was that the Fed would be looking at 2 rounds of rate hikes in the calendar year 2017. However, the current Fed meeting outcome indicates that the Fed may look to front-end rate hikes in 2017 to counter weigh the combined impact of sharp tax cuts and higher infrastructure investment. This could result in 3 rounds of rate hikes in 2017 rather than just 2 rounds. It also means that the Fed rates may get closer to 2% by end of 2017 and probably touch the 2.5% mark by 2018. Effectively, the latest Fed meet has not only raised the probability of more rate hikes in 2017 but has also increased the target Fed rates over the next 2 years. So what does this rate trajectory mean for emerging markets in general and Indian in particular?

What happens to flows into Emerging Markets?

The memories of January 2016 are still quite fresh in the minds of global investors. As global markets reacted to the Fed rate hike of December 2015, global markets lost nearly $12 trillion worth of market cap in the first few weeks of January 2016. While the 25 bps rate hike in December 2016 was already built in, there is likely to be an impact for sure. Firstly, there will be the risk of monetary divergence. Monetary divergence arises when one major economy follows a hawkish monetary policy and other large economies follow a dovish monetary policy. Currently, while the US is hawkish, the EU region and Japan are dovish. This will increase the volatility in global markets, bringing indices down. Secondly, Indian markets have already seen a sharp outflow. Normally, the impact of a rate hike is first seen in debt markets. FIIs took out $2.5 billion from Indian debt in November and another $2 billion in the first few days of December. That is because a rate hike in the US reduces the yield differential between India and the US and makes US markets a better bet on a risk-adjusted basis. Lastly, equity flows into most emerging markets including India could see a tapering in the coming weeks as most global investors will tread a little cautiously on emerging markets.

But, India may be better positioned vis-à-vis other EMs…

The good news is that despite the Fed rate hike, India may be better positioned compared to many other EMs. Here is why…

• The INR has shown a greater degree of stability and hence investors run a lower risk in dollar terms due to the calibrated currency policy of the RBI.
• The RBI tactfully chose to maintain status quo on rates in its December monetary policy as it would have further narrowed yield spreads between US and India. That will help matters.
• A Fed rate hike will make the dollar stronger vis-a-vis the INR and that means dollar defensives will benefit. We have stocks in IT, pharma, hydrocarbons and automobiles which stand to benefit from a strong dollar and also carry substantial weight in the index.
• Above all, a rate hike is a sign that the US economy is growing. That is good news for India, which looks to expand its economic footprint in the US. The massive infrastructure investment by the US worth $1 trillion could be just that opportunity.

Historically, India and the emerging markets have benefited from US rate hikes in the medium to long term. Notwithstanding short term jitters, any Fed induced correction will provide buying opportunities in the Indian equity markets.