If Yellen’s a hawk

After months of speculation about whether the US Federal Reserve’s new chief Janet Yellen would prove more dovish or hawkish than her predecessor, global markets had their answer last week. In her first public address, Yellen indicated that the Fed could hike its interest rates within six months of ending its bond buyback programme, maybe by June 2015. This jolted market participants, who until now believed that US interest rates would stay near zero for the foreseeable future. Emerging markets promptly went into a swoon, US treasury yields spiked and the Dollar Index soared. This is a wake-up call for Indian policymakers. A hike in US interest rates can have a much greater impact on foreign investment flows into India and the rupee than the dreaded ‘taper’ has had so far.

Now, it is clear that the doomsday predictions about the effect of the taper were exaggerated. The US scaling back its bond purchases by $10 billion each month hasn’t made a material difference either to global liquidity or to Indian markets. Since tapering began in mid-December, India has in fact received $10.5 billion in new foreign institutional investment (FII) money. This has helped the rupee strengthen, bonds rally and the Sensex scale new highs. But any spike in US interest rates can quickly jolt India out of this sweet spot. One should not forget that $7 billion of $10 billion FII funds flooding in this year have sought out Indian bonds and government securities, rather than stocks. And global bond investors base their allocations on just two factors — interest rate differentials between countries and their relative currency outlook. This is one of the reasons why the RBI has been calibrating its monetary policy to Fed announcements in recent months. Recall that belying expectations, the RBI has raised its policy rates by 75 basis points since September 2013.

Now, with Yellen hinting at a hike in US policy rates by the middle of next year, Indian policymakers cannot afford to relax their vigilance on either the Current Account Deficit (CAD) or the rupee. One implication of this is that it is best for the Centre to keep its gold import curbs in place for a while longer. With the prospect of a US rate hike looming, corporate India and retail borrowers too may need to brace for a prolonged period of high domestic interest rates. Given all the delicate balancing he has had to do to halt the downward spiral in the rupee, Governor Rajan may not be in any hurry to lower interest rates sharply now and risk an FII exodus from Indian bonds. As long as Yellen remains a hawk, Governor Rajan may not be able to play the dove, however much the markets may want it.

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