The US Federal Reserve raised interest rates by yet another quarter point in its monetary policy meeting yesterday, in a move largely factored-in by markets (CME Fed fund futures rate hike probability: 96%). In a rather expected sequence of events, the Fed now expects two more rate hikes in 2018, having upgraded both its growth and inflation forecasts amid sustained labour market tightening.
With the US central bank raising rates for the seventh time since monetary policy normalization cycle began in 2015, the European Central Bank (ECB) not trailing far behind and Bank of Japan not ready to cut rates further into the negative territory, the era of cheap credit, which began post the 2008-09 Global Financial Crisis, is evidently over. More importantly, with the US signalling a cutback in monetary policy stimulus since 2013, one would think that the likelihood of a repeat of emerging markets (EM) taper tantrum episode is no more a concern.
Rather unexpectedly, however, the months leading to the Fed’s seventh rate hike have seen an EM rout. Bond yields have hardened, while currencies have depreciated sharply (MSCI EM Currency Index: -3.4%), making this the second longest sell-off for EMs (IIF). Indeed, after dismissing US rate increases as a tail risk until 2017, the year 2018 has led to a reassessment by EM policymakers, amid a sharp rise in US treasury yields and recovery in the dollar, in turn, stoked by a record $1.8 Trn fiscal boost and the threat of import tariffs.
Recently, central bankers in Indonesia and South Africa have explicitly communicated the repercussions of US policy tightening; a steeper US interest rate trajectory and stronger US currency poses (1) upward pressure on the cost of servicing external debt and (2) an upside to domestic interest rates amid weakening domestic currency. In response to unexpected financial volatility and macro risks, Indonesia, Philippines, Turkey and Argentina have been compelled to tighten monetary policy. Of course, high levels of government and corporate debt in these economies has also contributed to capital outflows, with $1.6 Trn debt due to mature in 2018 and $1.7 Trn due in 2019 (IIF). Idiosyncratic factors such as lack of policy credibility (Turkey, Argentina) and election risks (Brazil, Mexico, Argentina, South Africa) have further exacerbated concerns.
Closer home, in what can be termed as entirely out-of-convention, a day prior to the June RBI policy rate hike, Governor Urijit Patel articulated risks from Fed tightening. In 2018, the combination of advanced economies’ (AE) monetary policy tightening and EM contagion fears have led to a cumulative $5 Bn FII outflows from the country. While it would be unfair to club India into the broader EM basket given the favourable change in macro mix and policy credibility, upside surprises to inflation, the likelihood of re-emergence of the twin deficits and upcoming 2019 elections have sewn a complex web of domestic uncertainty and risks. This, in turn, has played out by way of sustained increases in benchmark bond yields and a sharp depreciation in the rupee, with both breaching psychological levels in a short span of time.
How will India be impacted by future US rate hikes? The answer lies in expectations for future US rate hikes, as well as the susceptibility to AE rate tightening. Going forward, the extent of US rate hikes is expected to take a breather as (1) the short-term boost to growth from Trump fiscal stimulus wears-off, (2) actualization of US trade tariffs shave-off from growth and (3) adverse demographics and low productivity come into effect (FOMC GDP forecast: 2018: 2.8%; 2020: 2.0%). Focus on rising US fiscal debt and reduction in US-ECB rate differential as the latter ends bond-buying this year could contain future dollar strength. To this extent, there is limited scope for a sharp rise in US bond yields and the dollar. However, an end to global liquidity conditions in general (by ECB etc.) will continue to pose upside risks to India yields and policy rate, ceteris paribus.
When global risks loom, the focus must turn to reducing domestic macro vulnerabilities. With the country on the path of 7.5% growth this year, growth differentials vis-à-vis rest of the world are already supportive. The focus then turns to policy. Of the rising twin deficits, while not much can be done of India’s high dependence on energy imports, a reduction in current account deficit can be undertaken by way of policy impetus to exports (10% of GDP; China: 20%). Continued shoring-up of FX reserves by the RBI as a bulwark against sharp outflows is also likely to assist. Practising fiscal restraint, maintaining monetary-fiscal policy credibility and a proactive approach to supply-side inflation management needs no introduction. To the extent that these measures are undertaken, India will have prepared itself well by the time of the Fed’s eighth interest rate hike.
Prakriti Shukla is an economist based out of New York. She has previously worked with Yes Bank and Goldman Sachs in a similar capacity. Views expressed are the author’s own.