RBI's biggest challenge will be currency stability as US Fed hints at more rate hikes in 2017

Central bankers everywhere speak the same language and turn up being hawks or doves. It is not very different when it comes to US Federal vice chair Janet Yellen and her approach to monetary policy. Market expectations were that there would be an interest rate hike of 25 bps and this was announced by the US Federal Reserve’s policy makers yesterday where the target rate is now 0.75-1 percent. Two important additions have been that there would be further increases during the year and that the approach will be gradual. Both these pointers are significant. It is now widely expected that there would be two more such hikes with the target rate moving to an average of 140 bps by the end of the year. This has also been the approach of the Federal Reserve in the past where rates have been increased by 25 bps at a time – both in the upward and downward direction depending on the circumstances. This is where the term ‘gradual’ comes in; it smacks of a great degree of conservatism as the Fed believes that interest rates should move gradually in either direction to avoid sudden jerks to the economy. In fact, looking at the way the RBI has been calibrating interest rates, it appears that a similar approach has been pursued. [caption id=“attachment_3206610” align=“alignleft” width=“380”]  Reuters[/caption] The motivations for the rate hike are two-fold. The first is that unemployment is coming down mainly due to higher growth in the economy which is expected to move to 2.1 percent in 2017 from 1.9 percent in 2016. The US economy is definitely the brightest spot in the developed world as the others are still working hard to get out of the low equilibrium trap which has been aggrandized by the Brexit which has caused a major disruption in the EU economies with several others attempting to break away. Higher growth in the US is good news from the point of view of job creation though not so good for inflation, where the target is 2 percent which can be breached thus calling for monetary policy action. One must recollect that Donald Trump came to power on the back of a promise to cut taxes especially on the rich and spend heavily on infrastructure to boost the economy. Higher growth always goes with higher inflation in developed countries. Hence, expectations of higher growth has to be countered by proactive monetary policy and this is one reason why interest rates would be increased further going ahead unless something very different happens. This is one reason why the Fed has spoken overtly of possible future hikes albeit in a gradual manner as the build-up of inflation will follow this path. What are the implications for India? Higher interest rates mean that returns to domestic investors will increase. As investors are always forward looking expectations of interest rates moving up will get translated into higher domestic investment. As a corollary, there will be fewer funds flowing to other markets including India. This is one reason why we should be concerned because FPI flows into the debt segment has been buoyant in the past especially in government securities and with the interest rate differential between US treasuries and Indian GSecs narrowing down after being adjusted for exchanger rate risk, these flows could be affected. This move also comes at a time when the US government will be spending more on improving infrastructure within its boundaries which will mean more contracts for players. To this extent, there could be an impact of FDI flows to India too though it needs to be seen how exactly this story plays out. Will the Fed rate hike have a bearing on RBI policy stance? The answer is no, as our monetary policy is to be guided solely by the CPI inflation number which has been targeted at 4 percent with a band of 2 percent on either side. Hence, clues will be picked up from the inflation trends and policy action will not be affected by the Fed increasing rates. Besides, it has been acknowledged by the RBI that while it does consider all global economic developments when it discusses policy internally the over-riding factor is CPI inflation. However, the Fed hike cannot be ignored by the RBI as it does create distortions in the forex market as it affects the flow of foreign currency and hence exchange rate. This is always a concern because the RBI has to also ensure that the exchange rate movement is orderly and is driven largely by fundamentals rather than speculative forces. Presently the RBI is concerned by the accelerated appreciation in the rupee and is trying to talk to banks to reduce the speculative element. A sudden withdrawal of funds on account of higher rates in the US will cause even more concern. The Fed rate hike, it must be remembered comes at a time when other developed countries are still in the state of reflating as the fear of inflation is still secondary and the focus is more on fostering growth. The ECB had maintained its accommodative stance and the Fed’s decision would still be an outlier in the global arena. This rate hike hence will influence the entire flow of funds across markets, and India will not be left out. The dollar is expected to strengthen further in the course of the year, and hence while interest rate policy per se may be less affected by this development, currency stability will dominate the discussion tables at the RBI. The writer is Chief Economist, CARE Ratings. Views are personal