At the time that you read this column, the uncertainty over the global economy's biggest economic event of 2016, the US Federal Reserve (Fed)'s decision on interest rates, will be over. It is likely, or so 80 per cent of the markets believe as I write this, that the American central bank will hike its policy rate by a quarter of a percentage point. What will be more important is the 'guidance' that accompanies it. The majority view is that it will point to a gentle path of rate increases over the next year. Gentle would mean that there will be, cumulatively, half to three-quarters of a percentage point increase over 2016.
So far, so good. But some questions inevitably pop up. What will be the immediate impact of the rate hike? If you like to blame us economists for not agreeing on anything, let me point out that financial market analysts are not too far behind. Most forecasters take an intuitive view of things. The markets have prepared for so long for a lift-off by the Fed that the announcement of the decision itself is unlikely to have any impact. Thus, the hike is likely to have been priced in, and will not move the needle. The dovish guidance for the future could even trigger a relief rally.
Contrarians believe that the actual event of a rate hike, even if it is anticipated, is likely to lead to a swing in the markets. Non-dollar assets like commodities (particularly oil) and emerging market stocks and bonds have been under the shadow of negative sentiment for a while now. The Fed's move will just be another trigger for what appears to be a long-term sell-off in these assets.
The real short-term risk stems from the scenario in which the Fed stays out. Markets will see this as a reason to worry more about both the US and the global economy and might panic. With turbulence rising in every market, we could see the familiar flight to safety of dollar assets.
But, let's look beyond the near term and consider the long-term risks. Market watchers often fret when there's "too much consensus" and the market becomes completely one-sided as a result. This seems to be the case now. In such a situation, one has to be aware of the little niggles.
Let me explain. Despite a spectacular drop in the unemployment rate over the past year and a half and low gasoline prices, some of the things that economists assume should move in parallel have not been visible in the US. Wage growth and consumer inflation, for instance, remain low. In fact, the measure of retail inflation that the Fed uses is still below its official target. The general belief shared by the consensus is that this low inflation rate will persist, abetted partially by global deflationary trends. This will keep rate increases tepid going forward.
Yet, micro-level surveys of the US job market show evidence of increased job openings and higher quit rates - textbook signs of overheating of the market. The obvious risk that follows is that wages and retail price inflation (the two are inextricably linked) could rise much faster in 2016 than what the Fed might assume at this stage. The Fed's actions are likely to be data dependent, as the cliche goes, and if inflation data tends to get stronger, the pace of rate hikes will have to adjust to this. Faster rate increases will roil all financial markets and investors need to be prepared.
What are the risks for the Indian financial markets? My position on this is simple. While it does matter how gently the Fed hikes, the fact is that any move would mark a decisive end to the super-easy monetary policy regime that the markets have grown used to. Excessively low interest rates do strange things like compress the risk premium on assets. These would decompress as the Fed steps away from the current policy regime.
The initial channel through which the reversal transmits itself could be through currency markets. After the Fed move, depreciation pressure could build up for emerging market currencies and this includes the rupee. This could then spill over to other markets like stocks and bonds. The Reserve Bank of India seems to be battening down the hatches; but, if there is a major sell-off across markets, there is little that the central bank can and should do.
Over 2016, as risk perceptions change and investors find things to reject and others to champion, India could be a preferred destination for global money. For this, a couple of things need to change. I think the realisation that growth is slowly on the mend is seeping into investors' minds and this has to be reinforced.
There are three other things on my list of policy 'signals' that are imperative.
First, our policymakers need to change the perception that that the goods and services tax is the be-all and end-all of reform. Many other things are happening that seem to go relatively unnoticed by India watchers who seem fixated on this one (undoubtedly major) change in tax regime.
Second, some pressure will inevitably build up on the fiscal deficit on the back of government salary increases. This has to be handled deftly. Instead of going on a number chase and committing to a low deficit number that in the past has invariably meant a chop on vital capital spending, the government needs to buy some space for fiscal manoeuvre.
Third, it has to convince investors that banking and related reforms - everything from the bankruptcy code to UDAY, the financial restructuring of power distribution companies - will make a permanent dent on the bad loan problem for Indian banks.
A tall order, but one that is not entirely undoable - is it?
The writer is chief economist, HDFC Bank
These views are his own
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
