What does the US Federal Reserve's inaction mean for us

The Federal Reserve has finally decided not to increase interest rates on Thursday the 17th which will go down as a significant day in the monetary history of the world.

There were enough signals to justify a rate increase. The developments in the global economy were given as the main reason for not touching rates. The markets were wobbly as there was uncertainty on such action.

In fact, ever since China devalued the Yuan there was apprehension in the market on the Fed action as the limited pie of global exports was going to get distorted. How does this affect India?

Theoretically, we can be affected through the changes in ‘prices’. There are four sets of prices involved here. These are interest rates, exchange rates, inflation and stock prices.

The overall impact is positive in so far as India is concerned as of now which has been witnessed in the markets. However, it is understood that Fed would increase rates over a period of time and what we have witnessed is only a deferment of the same decision.

Interest rates are often linked with what happens in the west. Analysts have argued that when interest rates are moving down globally, India should not be far behind or as it is fashionable to say today- behind the curve.

In fact the argument has been stretched to say that we should be lowering the rates by a larger quantum to align with those of other central banks and not go in for a piecemeal 25 bps reduction, which has been the practice.

However, in our case, interest rates are determined by domestic conditions and this is what the RBI has maintained all through. As we have formally targeted CPI inflation, this would be the guiding factor for all practical purposes.

Interest rates cannot be reduced if inflation is not moving down or within the predefined rate of 4% with a flexible band of 2% on both sides. The action of the Federal Reserve becomes secondary in this exercise. In fact, when the RBI mentions the Fed action as a guiding factor, the implication is more from the point of view of the exchange rate.

The exchange rate becomes involved fully in the Fed exercise. When the Fed starts increasing interest rates, there would be a tendency for funds to move towards the USA from other developed countries; and for US investors to prefer domestic turf.

This causes a reversal of flow of funds through the FPI channel from the emerging markets to the USA, which in turn causes currencies to depreciate. One may recollect that in 2013 when news of the tapering programme was in the air, foreign funds withdrew from the emerging economies causing considerable volatility in the forex market across all the countries.

The fear was the same that there would be fewer funds available in the kitty. We have already witnessed negative FPI flows in August and September, which in turn put pressure on the rupee.

The decision not to increase rates has had a positive impact on the exchange rate which strengthened by 58 paise on 18th September, which can be interpreted in a way as being driven by sentiment.

The Fed has stated that the global economic conditions have slowed down that has caused them to take another pause. But it is possible that with the Yuan depreciating and gaining export advantage at the cost of the dollar, the time was not suitable for the Fed to increase rates which would have strengthened the dollar further.

Hence given that inflation was anyway low at around 0.2%, there was no pressing hurry to increase rates. In fact for 2015, the projection of inflation is 0.4% and 1.4% for core inflation.

Commodity prices have been coming down and would probably remain low for some time. The fact that the Fed spoke of global conditions being weaker than expected implies that commodity prices are not expected to recover any time soon, which from our perspective will mean more comfort on the oil bill as well as other imports especially of metals which will keep inflation down.

Hence, as long as the Fed holds on to interest rates, it is an indication that commodity prices will remain low. The signal sent when it raises interest rates could be taken to mean that demand would be increasing and prices would tend to rise over time, albeit gradually.

Last, stock prices are probably most sensitive to such news, which was observed from 2013 onwards. This works two ways. The first is the physical route where FPI funds move in or out as the case may be. This in turn causes either a bull or bear run in the markets when the FPIs are all thinking in one direction.

The other is sentiment. The news of the Fed not raising rates was first seen in the stock indices of USA which moved upwards on the 16th. The same was seen in the Indian markets, where the Sensex showed an upward tendency with the Sensex gaining over 300 points.

Hence, the Fed action on interest rates does cut across all borders and markets and has the power to make markets volatile. The stock and forex markets are more vulnerable and volatile as they tend to react to announcements.

Price inflation would be indicated by such actions as it gives the Fed perspective on the recovery process in the global economy. Interest rate action of other nations would be largely determined internally based on growth and inflationary conditions.

Given that inflation in populous countries tends to be concentrated more on the supply side, the general rules relating to price inflation emanating from demand side forces do not generally hold.

But we should remember that while the Fed has not changed interest rates as of now, an increase is inevitable with the conjecture being more on the timing of the same.

Until it happens we could expect volatility in the stock and forex markets to continue. Commodity prices would however continue to remain subdued as the growth signs in the USA though positive are not of the accelerating nature.

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