What the sizeable 75-bps hike by the US Fed means for the Indian economy

The 75-basis point hike in the Fed rate-- the biggest one-time increase in nearly three decades -- to between 1.5-1.75 per cent shows the aggressive stance of the US Central Bank to tame inflation, which is currently running at 8.6 per cent. Clearly, more hikes are expected from the US Fed to bring down retail inflation to its targeted level of 2 per cent. 

In its June monetary policy, the Reserve Bank of India had hiked the short-term rates by 50 basis points to 4.90 per cent as against the inflation rate of 7.04 per cent. The RBI has a target of containing inflation at 4 per cent with an upper band of 6 per cent. While the Indian economy is relatively on a better footing than the US, the rising interest rate trajectory will have implications for the Indian economy. 

Let's take a look:

Narrowing interest rate differential

The US had a near zero short term interest rate in the post global financial crisis in 2008, which went on till 2015. Over the next five years, the Fed rate rose to a high of 2.5 per cent before settling around 2 per cent just before the COVID outbreak. In the post-COVID period, the rate once again moved down to near zero levels to support the economy. Globally low interest rates supported emerging markets such as India in attracting dollar inflows. But this trend is now reversing, with yields on US treasuries rising and the dollar also strengthening. The rapid rise in global yields is narrowing the interest rate differential between the US and India because of faster hikes by the US Federal Reserve. This would mean acceleration in the outflow of dollars from the debt and equity markets from India. Clearly, the current 75 basis point hike in the fed rate will make the Indian market less attractive. RBI Governor Shaktikanta Das did mention in his monetary policy statement that the "safe haven demand for the US Dollar has increased."

Pressure on the value of the domestic currency in relation to the US Dollar

The domestic currency has been weakening at a faster pace since January this year. The Rupee has already depreciated from 74.25 in January to 78.17 against the US Dollar. The support from dollar inflows is gradually disappearing as foreign investors' selling in the Indian equity markets is continuing unabated. As against net positive investments of Rs 25,752 crore in the entire year 2021, foreign investors have already made a net outflow of Rs 1.92 lakh crore in the first 5 months of 2022. The massive selling is likely to continue as the Fed has indicated a further hike of 50 -75 basis point at the next meeting. "Inflation warranted a bigger hike today," said Jerome Powell, Chairman of the Federal Reserve. In addition, rising crude oil prices is also adding to the woes of the Rupee value against the US Dollar.

Threat of imported inflation

There is an increased threat of inflation coming through the currency route. Assuming the global prices remain the same, the depreciation in currency will increase the landing cost. The RBI, however, has been intervening in the forex market by using its forex reserves kitty to reduce volatility, but the Rupee has been on a downhill. The forex reserves are already down from USD$640 billion to USD $600 billion. India is a big importer of crude, electronics, and gold, which are used widely in the economy. In fact, the rising imports are already widening the current account deficit (CAD). The CAD is expected to cross 3 per cent of GDP in 2022-23. The rising global rates are impacting India's macro. 

A faster withdrawal of liquidity is needed to fight inflation

Globally, monetary policy uses the tool of liquidity and cost of money to control inflation. The RBI has already triggered the cost of money tool by raising the short-term interest rates, but the surplus liquidity is still high in the system. Given the aggressive stance of the Fed and other global central bankers, the RBI has to reduce the liquidity levels in the system. The current daily surplus liquidity is of the order of Rs 7 lakh crore, which is very high.  During the normal conditions, the surplus liquidity used to be around Rs 1-2 lakh crore in an accommodative stance. "We are completely focussed on withdrawal of accommodation. The surplus liquidity is higher than the pre-pandemic level. The liquidity withdrawal going forward would be calibrated," Das had said in a recent media conference. The RBI Governor has articulated in the past that the RBI will normalise surplus liquidity over a period of 2 to 3 years.  "All that we want to convey is that we do not want to take abrupt action," said Das.

Also read: US Fed hikes rates by 0.75 percentage point, flags slowing economy