Fed Rate Hike - Indian Implications

The US Federal Reserve has yet again affected a 0.25% hike in its overnight rates, which now stand at 2.75%. This is the seventh quarter percent hike since the Fed started raising rates last June in its pursuit of tiding in the rising inflation. However, while the central bank kept the measured tone intact, it indicated that it is growing more concerned about the inflation. Give us a break, Mr. Greenspan. That does sound stale now!

In his recent testimony to the US Senate Banking Committee, Greenspan had hinted at a further hike in interest rates, citing reasons like improvement in the US economic fundamentals and low savings of consumers. He had further indicated that the rise in rates would continue to be 'gradual' (read measured) and that it was an 'imperative to restore fiscal discipline in the United States to help narrow the huge trade deficit.'

While not much should be read into this ¿measured¿ rate hike as this seems a repeat of what the Fed has consistently maintained in the past year, Indian investors should note that these are few of those times when Greenspan has confessed that the problem of high deficit is a consequence of the extensive liberal policies of the Fed with respect to interest rates in the past 2 years.

In the recently held 'Advancing Enterprise 2005 Conference' in London, Greenspan had owned up that the fall in US interest rates since the early 1990s has supported both home price increases (the asset bubble as it is termed) and, in recent years, an unprecedented rate of existing 'home turnover'. This combination has then led to a significant rise in debt on account of home mortgages. What Greenspan meant from the latter (home turnover) was that the sharp rise in home prices has created capital gains for owners, which become realised with the subsequent sale of a home. A large proportion of this money is then used to purchase another home and the remaining part is used for 'consumption' purposes. This has been the chief perpetrator of the rising US personal dissavings. And so the Fed decision to now raise interest rates at a faster clip to reign in the bubble.

A case in point was the minutes of the meeting of Federal Reserve (held on December 12, 2004) that were released a couple of months back. Some accompanying facts of the minutes led to investors across the world panicking in belief that the faster rise in the US interest rates will lead to the 'hot' FII money reversing its flow, back towards the relatively safer US treasury bills and bonds.

The minutes of the aforesaid meeting indicated that the US economy expanded at a moderate pace in the second half of 2004, with both consumer and investment spending remaining robust. However, while core inflation remained subdued, prices rose slightly higher than in 2003. This was much owing to the indirect effects of higher energy prices. It was also indicated that the recent depreciation of the US dollar against key currencies was also putting pressure on inflation, thus increasing risks of a faster rise in prices going forward.

These key details of the Fed meeting led market participants to believe that the US central bank might raise interest rates faster than in the past, thus increasing risks of re-allocation of FII money back to US equities in 2005. Apart from that, the fact that economic policies across the globe are now more integrated than ever before, investors seemed to have believed that in light of the US Fed raising interest rates at a faster pace, central banks across the world would follow soon.

So, what should Indian investors do?

In light of the concerns that have been mentioned above with respect to a faster rise in US interest rates and FII flows reversing their direction, thus leaving local investors in the lurch, we suggest that investors should not bank on just FII inflows to drive markets to new highs. Economic theory suggests that a country cannot sustain a GDP growth that is much higher than the prevailing interest rates as it leads to high inflation and overheating. Given the fact that the US interest rates still lie at 2.75% as compared to the GDP growth of around 3.5%, there is a case in point for the Fed to raise rates fast, at least till the 3.5% levels.

As for Indian investors, given the sharp rise in stock prices over the last two years, they have to be cautious when it comes to investing in equities at the current levels. Apart from the fact that return expectations have to be toned down, investments should be made on a staggered basis.

Source : Equitymaster