Fed hikes rate: Indian inflation may quicken, dollar inflows slow but growth is insulated

The raising of interest rates by the US Federal Reserve was more or less buffered in by the market this time. The reason is that there has generally been consistency in its approach to rate changes depending on the unemployment rate which is almost predefined at 4.6 percent which indicates that the economy is growing.

Growth is always positive for any economy and a rate hike cannot be justified except on grounds of inflation increasing or rather potentially displaying such tendencies. This is different in India where inflation is basically a cost side phenomenon and rarely do we have a situation where higher growth engenders high inflation in the range of say 10% which is almost always a food shock led rate.

 Fed hikes rate: Indian inflation may quicken, dollar inflows slow but growth is insulated

The US Federal Reserve building in Washington. Reuters

What one can conclude here is that the Federal Reserve will continue to increase rates in 2017 and while 50-100 bps can be taken to be certain, higher threat of inflation can lead to a more aggressive stance. However such a conjecture can be checkmated by the new President Donald Trump who has pledged to push for growth with tax cuts and aggressive expenditure.

In such a scenario his view would run counter to the Fed and it will be interesting to see in case he pressurises the Fed to act in a different manner. Hence the test will really be whether or not the Fed can work independently from the government. This is an issue which comes up often in India about the central banks's independence.

What are the implications of this rate hike for the rest of the world? Higher rates have an impact on two variables which no country, including India, can escape. The first is the flow of investment. Higher rates in the US automatically mean that debt earns better rates back home and with the US being the biggest investor the flow to emerging markets will slow down.

It may be recollected that the QE programmes of the Fed coupled with almost zero interest rates had caused investment to flow to emerging markets which were the faster growing ones. This was helped by the fact that growth was stronger in these countries. Now with growth prospects in the US being better, no support for QE which has been withdrawn and higher rates in the US to prevail, investment is bound to remain in the US with the possibility of reverse flow from developing countries also possible.

Second higher rates is symptomatic of a strong country which, in turn, makes the currency stronger. Hence if the Fed keeps increasing rates the dollar will keep strengthening. This is so as higher rates get in more dollars thus improving the balance of payments. This, in turn, will make other currencies fall.

What does this mean for India?

First there will be pressure on FPI flows. Investment in equities will be driven by other factors. But those in debt will be under pressure. This is so as our rates are coming down at a time when Fed is increasing rates. This will widen the rate differential for investors. Add to this a weaker rupee and the outflows from debt will start. At best there would be no outflow but inflows will slow down sharply.

Second is the issue of the rupee-dollar rate. The rupee will fall both because our fundamentals will weaken and that we have to keep up with the currency falls in other countries. The RBi will have a role to play here. In the past also we have seen similar challenges.

Third the RBI interest rate policy, however, will not be affected much as it is being driven by inflation trends. Hence there will be no impact on its policy formulation.

Hence, the Fed rate hike should not be looked at as a single measure. This is the start if a series of rate hikes which can be punctuated only by Donald Trump's ideas. The dollar will strengthen and investments flow will reverse and move back to the US. India cannot escape both these repercussions though interest rate policy will remain independent. Inflation can rise if rupee falls sharply, but overall growth should be insulated given that ours is a domestic oriented and driven economy.

The author is chief economist, Care Ratings. Views are personal

Updated Date: Dec 15, 2016 09:47:34 IST