Increasing interest rates

Markets will adjust to tighter financial conditions

The cost of money is rising. The yield on 10-year government bonds is at the highest level in over two years and has gone up by over 40 basis points since September 2021. Although normalisation of yields is necessary and healthy, it will have implications for both the government and financial markets. The cost of money is increasing because of multiple reasons. The government’s borrowing needs remain elevated, which would keep the supply of bonds at higher levels. While the inflation rate based on the consumer price index has come down and is now within the tolerance band of the Reserve Bank of India (RBI), price pressure remains and is being reflected in double-digit wholesale price index-based inflation. However, the biggest factor driving bond yields is normalisation of liquidity conditions by the RBI.

The central bank was maintaining significantly higher levels of liquidity in the system to keep market interest rates low and contain the disruption caused by Covid-19. This also facilitated a significantly higher level of government borrowing at lower rates. However, maintaining excess liquidity for an extended period can create risks, such as fuelling both consumer and asset price inflation. Lower interest rates and easy availability of money, for instance, have been pushing up stock prices. But the RBI has started the normalisation process and is now unwinding excess accommodation. It has stopped the bond-buying programme and is draining out liquidity from the system through instruments like the variable rate reverse repo. Given the inflationary pressures in the economy and the risks associated with excessive policy accommodation, it can be argued that the RBI should have started this process much earlier.

The RBI is not the only central bank looking to normalise policy conditions. The minutes of the December meeting of the US Federal Reserve indicate that it may increase interest rates sooner than previously expected. Most traders believe that the first hike may come in as soon as March. Goldman Sachs expects the Fed to increase rates four times this year. Economic recovery from the pandemic-related disruption has been stronger than expected in the US and the unemployment rate has fallen below 4 per cent. But the inflation rate has been running way above target. It is expected to have gone up to 7 per cent in December. Most economists believe the Fed is behind the curve. The US central bank is also expected to start reducing the size of its balance sheet, which has more than doubled since the outbreak of the pandemic.

Higher interest rates in the US and tighter global financial conditions could lead to an outflow of capital from emerging market countries. Foreign portfolio investors have been net sellers in Indian markets over the last quarter of 2021, for instance. Higher interest rates would also affect equity prices as debt becomes comparatively more attractive. Further, the pandemic has pushed up public debt all over the world, including India. Higher public debt and interest rates would limit the ability of governments to spend, which would affect growth and stock market valuations in the medium term. While earnings in India have grown in recent quarters on the back of cost-cutting and lower taxes, it may not be sustainable in the absence of decent revenue growth. Stock markets would need to adjust to tighter financial conditions in the coming months, which could lead to correction in valuations.