After the two-day meeting of the Federal Open Market Committee (FOMC), US Federal Reserve Chairman Jerome Powell said that the central bank could begin scaling back asset purchases in November this year, which should end around the middle of next year. He also hinted that the Fed rate will increase interest rates only after completing the bond tapering process.
Here’s how the Fed decision can impact Indian financial markets:
Impact of scaling back asset purchases
The US Fed is currently buying back USD $120 billion worth of bonds and securities per month from banks and financial institutions. This large bond-buying of long-term bonds helps in reducing the long-term interest rates in the economy and supports the revival of the overall sentiments in the market. US Fed has now given a signal and a timeline of sorts for slowing down the purchases from November onwards which would go till June-July next year. The financial markets in India and also the Reserve Bank of India (RBI) will start to factor in the likely outflow of capital from India especially the foreign portfolio investments. Since the Fed has given a clear signal, there is unlikely to be any knee-jerk reaction on the currency value against the US dollar or the stock market.
Impact of likely interest rate hikes
The US Fed rate or the short-term interest rates are near-zero levels of 0-0.25 per cent since March last year. The Fed rate is the rate at which the banks borrow money from the central bank. Clearly, the Fed hasn't touched the short-term rates. The guidance for a hike is also towards the second half of the next year. As per Fed meeting details, only half of the members are of the opinion that the rates should increase in 2022. Clearly, the low short-term interest rate regime is expected to continue for a longer time till the US economy fully recovers and the unemployment rate reduces.
How should RBI prepare its exit from easy monetary policy?
Like the US Fed, the Indian central banker has also infused liquidity in the market by keeping the interest rates low. The objectives are similar to support the nascent economic recovery as there are still fears of a third wave. The RBI will also have to start exiting from the ultra-loose monetary policy as it has adverse implications on the management of inflation and distortion in asset prices. Such a loose monetary policy also has the potential to create bubbles in the market, which will have larger implications for the political economy if something goes wrong. RBI's exit from the easy monetary policy will take place by way of first changing the stance from accommodative (surplus liquidity) to neutral (liquidity in little deficit mode) or by narrowing the repo and reverse repo band from current 65 basis points to 35 basis points, which was the norm during pre-pandemic days. The RBI had lowered the reverse repo rate drastically to discourage banks from parking surplus funds with it. Reserve repo rate is the rate at which RBI absorbs the surplus liquidity from the system.
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