When the Fed sneezes, the whole world catches a cold!
Just a couple of weeks ago, the world market rejoiced over hopes that the US Federal Reserve could go slower on interest rate increases.
Fed Chair Jerome Powell confirmed that smaller interest rate hikes were likely ahead even though he cautioned that monetary policy may remain tight until clear signs of inflation coming down significantly is visible.
But this optimism soon lost steam after strong macro data in the US reminded the market that the Fed still has the comfort to lift rates aggressively.
The US Federal Reserve is the most powerful central bank in the world at the moment. Its action on the policy front has a ripple effect across the globe. Forget about rate hikes, even a slight hint on the trajectory of a rate hike shakes up markets.
Investors might feel disappointed that by lifting rates aggressively, the Fed is aggravating the risk of a recession and shattering market sentiment. But the Fed has a job to do- to keep inflation down and increasing rates is its most effective weapon against soaring inflation.
What is the expectation this time?
The US FOMC meeting outcome is due on December 14 and after raising the interest rate by 75 basis points at each of the previous four meetings, there are expectations that a 50 bps hike is possible this time.
Economists polled by Reuters unanimously expected the US Federal Reserve to go for a smaller 50 basis point interest rate hike on December 14.
Why is the US Fed hiking interest rate?
After the Covid-19 pandemic hit the world, the US Fed and other central banks slashed key lending rates to historic low levels to ensure that their financial system had adequate liquidity while economic activities were restricted due to Covid curbs.
Before the pandemic could end and the central banks begin winding up excess liquidity, the Ukraine war began which shot up the commodity prices due to the demand-supply mismatch. In the US and some parts of Europe, inflation surged to multi-decade high levels. India, too, faced the heat as its retail inflation, measured in Consumer Price Index (CPI), has been above 6 percent, which is the top level of RBI's tolerance band, for the last 10 months.
Now, the Fed is hiking rates because it has to bring inflation down.
Because inflation is bad for the economy.
We all know that inflation in simple terms is the increase in the prices of goods and services. When inflation rises, people have to shed more money for consumption. This erodes their purchasing power and hits demand which eventually hits production and economic growth.
High inflation leads to low purchasing power which leads to low consumption which leads to low demand which leads to lower production and lower economic growth. And the worst part is that this cycle repeats because a weak economy means weak production, low wages and so on.
IMF says: "In an inflationary environment, unevenly rising prices inevitably reduce the purchasing power of some consumers, and this erosion of real income is the single biggest cost of inflation. Inflation can also distort purchasing power over time for recipients and payers of fixed interest rates."
Inflation is a big threat and it is Fed's responsibility to keep inflation under permissible limits.
What does it mean for the Indian economy and the market?
After a rate hike by the US Fed, the difference between interest rates in the US and India shrinks which affects the currency trade negatively. The dollar and the US treasury yield become attractive in the US and the Indian market begins to see capital outflow.
Moreover, the rupee gets weaker and it prompts rate hikes in India. If the rupee falls significantly, the RBI may be forced to sell some dollars to help the domestic currency. This depletes domestic forex reserve.
The biggest shock for the market comes in the form of heavy selling by foreign investors. Usually, emerging markets give better returns than developed markets but when rates are raised, the magnitude of return becomes less attractive. In this scenario, foreign investors take money out of emerging markets like India and invest in US stocks which are relatively less volatile.
This year so far, the Indian market has reacted both ways after the Fed outcome.
What should retail investors do?
A rate hike is expected and the market might have discounted it. What will set the mood for the market is a hint from the Fed on the trajectory of the rate hike.
Even economists and experts have been warning that the US may see a recession in 2023, and the Fed may continue to hike rates unless it is convinced that the inflation has come down and would not rebound.
This is likely to keep the market volatile. Retail investors can bet on domestic-centric sectors as they are less likely to be impacted by a recession in the US. Invest for long-term on quality stocks, add on dips and adjust your portfolios as per the market situation, say experts.