Impact of US Federal Reserve rate hike on Indian markets

US consumer price inflation reached a new high in 40 years in June, up 9.1% year-on-year, according to data released Wednesday (July 13th) by the Bureau of Labor Statistics. Inflation is well above forecasts of 8.8%, according to US-UK financial markets data provider Refinitiv, with energy accounting for nearly half of the monthly inflation surge.

In addition to the domestic impact, the latest US inflation release is expected to have a significant cascading impact on emerging market economies such as India, where sustained capital market outflows have unnerved markets. stock markets and led to a weakening of national currencies.

As the US Federal Reserve prepares to raise rates further, fund outflows from emerging markets are expected to continue, putting pressure on currencies and markets.

What is the impact of high inflation printing?

The Fed looks for the basics when assessing inflationary trends, and the latest releases should prompt the central bank to further intensify its aggressive streak of rate hikes that began early this year. With the Fed expected to raise its benchmark interest rate by at least 75 basis points at its next monetary policy meeting on July 26-27, the latest inflation figures push the US central bank to go even further.

According to Charlie Bilello, Founder and CEO of Compound Capital Advisors, after Wednesday’s inflation release, “the market is now pricing in an 83% chance of a 100 basis point rally at the FOMC meeting in 2 weeks. , up from 0% a week ago.” The last time the Fed raised rates by 100 basis points in a single meeting was in 1981, incidentally the last time inflation rose. exceeded 9% in the United States before the last release of inflation data in June.

The immediate impact was that the US dollar hit a 20-year high against a basket of currencies, and the euro fell below parity against the US dollar. The euro dipped to $0.9998 against the greenback, dropping below the $1 level for the first time since December 2002, before rebounding slightly on Wednesday, mostly on expectation of a bigger rise in interest rates. the US Fed.

The Fed’s monetary policy meeting is expected to see a shift in gear in its rate-hike action, following a three-quarters percentage point hike last month – its most aggressive move since 1994. The June hike, the third since March, came after an unexpected spike in US inflation in May.

The annual inflation rate in the United States accelerated to 9.1% in June 2022, the highest since November 1981 and above the market forecast of 8.8%. (Chart source: Trading Economics)

More importantly, the US central bank could signal similarly large hikes later this year, which could potentially hurt investors’ already shaky outlook for the markets.

What is the scope of the Fed’s upcoming action to fight runaway inflation?

While markets have largely priced in the reversal of Fed policy, the pace of the rise is raising further concerns, as the US central bank is now under renewed pressure to tame inflation as oil prices rise. the largest economy in the world are increasing. There are now clear indications that the Fed would be much more aggressive in the intensity of its rate hikes, following advice offered by Fed Chairman Jerome Powell.

Soaring inflation is seen as a political headwind for US President Joe Biden ahead of November’s midterm elections. Biden had said earlier this year that it was “appropriate” for Powell to adjust Fed policies. And congressional Republicans, according to an AP report, endorsed Powell’s plans to raise rates, providing the Fed with rare bipartisan support to tighten credit.

After Wednesday’s data release, Biden said June’s CPI inflation reading was “unacceptably high” but claimed it was “also outdated” as fuel prices fell in course of the last 30 days. “Energy alone accounted for almost half of the monthly increase in inflation,” Biden said, according to a CNN report. “Today’s data does not reflect the full impact of nearly 30 days of lower gasoline prices that have reduced the price at the pump by about 40 cents since mid-June. These savings provide significant breathing room for American families. And other commodities like wheat have fallen sharply since that report.

What is the impact of the Fed’s upcoming action to moderate inflation on global markets?

Traders in all markets have been looking since the start of this year for signs that the Fed could be more aggressive in undoing the stimulus that fueled stock market gains in all geographies.

The new projections in response to the path of inflation are seen as a definitive move to anticipate the reversal of the central bank’s expansionary monetary policy put in place in early 2020 to reinvigorate the US economy amid the outbreak. of Covid-19. Some of that support came in the form of an extraordinary bond-buying program, which aimed to drive down long-term interest rates and catalyze increased borrowing and spending by consumers and businesses.

The Fed’s anti-inflation action comes amid criticism that the US central bank has lagged the inflation curve. Powell and other Fed officials argued until early this year that inflation in the United States was just a temporary problem related to supply chain issues. Prices have skyrocketed since then, in part due to external factors including the war in Ukraine and continued Covid-19 shutdowns in major Chinese manufacturing hubs.

Why are Fed signals important?

Like other central banks such as the Reserve Bank of India, while the US Fed conducts monetary policy, it influences employment and inflation primarily by using policy tools to control the availability and cost of credit in the economy. ‘economy.

The Fed’s main monetary policy tool is the federal funds rate, changes in which influence other interest rates – which in turn influence borrowing costs for households and businesses, as well as broader financial conditions. wide. Additionally, the bond buying program, also known as quantitative easing, was introduced in 2020 as an extraordinary measure to help financial markets and the economy counter the impact of the pandemic. .

This bond purchase was an unconventional monetary policy tool (which was also deployed during the global financial crisis), using which the central bank buys longer-term securities on the open market in order to increase the money supply and encourage lending and investment. Buying these securities increased the supply of new money into the economy and eventually drove interest rates down, while expanding the central bank’s balance sheet.

The Fed has now halted the process of reinjecting the proceeds of an initial $15 billion of maturing Treasury bills into the US government debt market, signaling the decision to shrink its expanded balance sheet by $9 trillion. .

The Fed isn’t the only one intent on raising rates. Last month, the Bank of England announced its fifth rate hike since December, pushing its benchmark rate above 1% for the first time since 2009. Australia, Brazil and Canada also raised their rates, while the European Central Bank has indicated that it could rise over the next two months.

In India, the RBI has implemented a cumulative increase of 130 basis points in the effective policy rate — the permanent deposit facility rate and the repo rate hike of 90 basis points — over the past three months (one point base equals one hundredth of a percentage indicate). While CPI inflation eased slightly to 7.01% in June from 7.04% in May, it was still the sixth month in a row that CPI data exceeded the upper 6 range. % of RBI. the RBI is widely expected to raise the policy rate by up to 35 basis points at its next meeting in August. Benchmarks in India were up at the open of trade on Thursday.

How do rate cycles work?

Interest rate hikes are the main monetary policy tool used by central banks to deal with sporadic surges in inflation. When interest rates rise in an economy, it becomes more expensive to borrow; households are therefore less inclined to buy goods and services, and companies are deterred from borrowing funds to expand, buy equipment or invest in new projects.

A subsequent decline in demand for goods and services eventually depresses wages and other costs, which in turn helps keep runaway inflation in check. Even if the links between monetary policy and inflation and employment are neither direct nor immediate, monetary policy is a key factor in the fight against runaway prices.

Theoretically, a signal of interest rate hikes in the United States should be negative for emerging economies, especially from a debt market perspective.

Emerging economies such as India tend to have higher inflation and therefore higher interest rates than in developed countries. As a result, investors, including foreign portfolio investors, tend to borrow from the United States at lower interest rates in dollars and invest that money in bonds of countries like India in rupees to get a higher interest rate.

What impact will more aggressive Fed rate action have on other markets, including India?

A stronger-than-expected rate hike in the US could have a triple impact.

When the Fed raises its key rates, the spread between the interest rates of the two countries narrows, thus making countries like India less attractive for carry trades on currencies.

A high rate signal from the Fed would also mean less growth stimulus in the United States, which could still be bad news for global growth, especially when China is reeling from a crisis. real estate.

Higher yields in US bond markets could also trigger a rotation in emerging market equities, dampening enthusiasm among overseas investors. There is also a potential impact on foreign exchange markets, resulting from outflows.