By Invitation. RBI’s rate setting will be a tight-rope walk

The recent quarter-point rate hike by the US Fed signalled the process of getting interest rates up to what it terms their ‘normal’ levels. It also indicates the end of the accommodative policy that held for nearly a decade after the 2008 crisis.

The course of Fed policy changes has been guarded because, as is often said, the US Fed runs a global monetary policy and has to take into account a variety of factors.

It had to worry about the impact of prolonged low interest rates on the health of financial institutions as also the fear of asset bubbles building up. But it had also to reckon with the rapid appreciation of the dollar, which could accelerate with rate hikes, hurting imports and widening the trade gap further.

Even more crucial is the impact on global economies; the dollar being the world reserve currency, its rapid appreciation could hurt countries that have accumulated large dollar debt at cheap rates, which could trigger a default contagion.

The Fed, in fact, began the process of scaling down as early as in 2014, but later events such as Brexit, the steep fall in oil prices and rapid dollar appreciation caused it to hasten slowly.

But now, with the second hike in three months, attention will be on the path they will traverse in 2017 and beyond, since it had indicated that a cumulative 3/4 percentage point increase would be likely during 2017. This means there will be at least two more hikes this year.

The impact of the rate hike in India is largely expected to be on the currency front, though stock markets could also face short-term volatility due to capital flows.

While the previous hike was muted, with FPIs having factored the same by pulling out large investments early, the worry this time around is the number of rate hikes in store during 2017 and beyond, which could mean sustained pressure on the rupee.

Continued rupee depreciation could worsen the trade deficit through increased oil bills and stoke inflation, which is on the rise already.

If low inflation was holding back the Fed from hiking interest rates much earlier, the RBI seems to be preparing to combat higher inflation. This surprising change in stance, after a longish ‘accommodative’ phase, means that not only are rate cuts ruled out for the present but also opens up possibilities of rate increases if required.

The RBI’s worries on retail inflation are coming from rising food prices, hardening oil prices and rupee depreciation. The play of interest rates and inflation in the two countries is interesting.

The message from the US rate hike is that the economy was now healthy enough to grow without the crutch of low interest rates and also take in some inflation; in its view, the risks from prolonged low rates outweighed their benefits, particularly their impact on banks’ profitability and asset bubbles.

The experience from the accommodative stance also seems to weaken the case for lower rates. Credit growth did not pick up with rate cuts; neither was banks’ profitability impacted (it was low even at higher lending rates).

The RBI is now telling banks that any further reduction would need to be effected by the banks themselves. Lower interest rates also hit FPI flows, which turned negative during 2016, for the first time since 2008, due to huge outflows under debt investments.

If domestic rates now fall further at a time when interest rates are going up in the US, the outflows could accelerate and place greater pressure on the rupee. However, it is believed that the RBI’s neutral stance could make domestic bond yields more attractive for FPIs and bring back inflows.

Sustained GDP growth and comfortable reserves are undoubtedly positives to counteract the pressure on the rupee but the challenges will be not just from interest rate changes in the US but from the increased uncertainties in global trade. All said, RBI’s rate setting will be a tight-rope walk, balancing between the needs of growth and maintaining stability in the internal and external value of the rupee.

The writer is an Independent Consultant

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