When the US Federal Open Market Committee (FOMC) meets on March 14-15, it will be a big question on whether they will look to another rate hike. Interestingly, the markets seem to be almost betting with certainty about a rate hike on March 15th. In fact, the probability of a rate hike, as implied by the Fed Fund Futures, has surged from around 35% to 95% in the last 15 days. Such sharp shifts in probabilities are rarely seen because even till a couple of weeks back, traders were highly sceptical about a rate hike. The current probabilities indicate that the Fed may not only hike rates by 25 basis points in March but also give a very hawkish commentary and also speed up the pace of future rate hikes. Why is a Fed rate hike so likely in March and what could be the larger implications for emerging markets like India?
Reason 1: A Donald Trump fiscal push; sooner rather than later…
In the last couple of speeches by Donald Trump the markets were sorely disappointed that there was nothing concrete on the tax cuts front or the fiscal stimulus front. But the Fed is of the opinion that the fiscal stimulus will come sooner rather than later. The US is once again approaching its debt ceiling and the only it way could sail through this time is by promising large scale reforms. These reforms will be in the form of corporate and individual tax cuts as well as greater spending on infrastructure. What the US government is veering towards is a greater thrust on fiscal policy to give a boost to the economy. As Trump has consistently maintained in his speeches; he wants to reduce taxes for corporates and individuals so that companies do not have any incentive to go out of the US in search of tax havens. Additionally, the huge tax cuts for individuals will give a big boost to spending and demand in the economy.
It is expected that the Fed will have to time a rate hike to ensure that the fiscal stimulus does not result in runaway inflation in the economy. Also the liquidity surge in the economy due to tax cuts will get partially absorbed by the monetary tightness induced by rate hikes.
Reason 2: US Inflation is getting closer to the targeted 2% mark…
Inflation in the US has moved closer to the 1.7% mark and looks set to touch the original target of 2% sooner rather than later. Over the last couple of years, US inflation stayed surprisingly benign due to a mix of weak oil prices and weak prices of commodities globally. Both these have already changed and could change further in the months to come. Consider oil for example! The price of Brent crude touched a low of $26/bbl in early 2016 but has since bounced back closer to the $55/bbl mark. In fact, crude has stayed above the $50 mark consistently due to the OPEC deal to restrict supply. The US, despite its huge stockpiles, is also benefiting from higher oil prices as a lot of its shale wells are becoming viable. Hence it may not want to upset the applecart and will prefer to let prices of oil remain at a buoyant level.
Another key reason for low inflation in the US was weak commodity prices. Over the last few months, key industrial commodities like copper, zinc, steel, aluminium are all seeing a massive rally. The reasons are not far to seek. Firstly, the US is planning to invest nearly $1 trillion into infrastructure and that is likely to give a boost to demand for industrial commodities. Secondly, the China Railways is planning a massive $400 billion investment to revamp its rail infrastructure and that is also likely to drive the global demand for industrial commodities. In a nutshell, US inflation is likely to get beyond 2% in the coming months and therefore a rate hike would be par for the course.
Reason 3: The world is much better prepared this time around to absorb a rate hike…
When the US hiked the Fed rates by 25 basis points in December 2015, it was for the first time in 9 years that rates were being hiked. Not surprisingly, there was a panic reaction globally as nearly $12 trillion of global wealth got wiped out in the first 2 months of 2016. However, the subsequent rate hike of 25 basis points in December 2016 hardly created a flutter. There are two reasons for this. Firstly, the global markets are not as brittle as they were in early 2016. The Euro has lived to fight another day while the BREXIT does not appear to impose a major financial burden on UK. China is still growing, albeit at a relatively slower pace. More importantly, the bear market in oil and commodities has shown distinct of bottoming out. All these are encouraging signals. Secondly, the global markets are confident that the monetary tightness of the Fed will be more than compensated by the fiscal stimulus of the Donald Trump government.
So, can Emerging Markets like India breathe easy now?
That may be a slightly simplistic explanation of the whole issue. A lot will depend on the language of the Fed and the hawkishness implied. If the US Fed hikes rates by 25 basis points in March and puts off rate hikes for some time, then the impact may not really create a flutter. However, if the tone hints at hawkishness and a quicker pace of rate hikes than FPI flows are likely to turn sharply risk-off. That means money may move out of emerging markets like India, Taiwan and South Korea into the US where the yield will be much more attractive in risk-adjusted terms. We saw that risk play out in mid-2013 and again in early 2016. That is a risk that the Indian markets cannot completely rule out!