Turbulence ahead

The US Federal Reserve has begun a full-fledged war against inflation with a 50 basis points hike in Federal Funds rate and commencement of balance sheet contraction from June. The repercussions of this aggressive tightening will unravel in the coming months. Regulators in emerging economies need to get ready to face heightened volatility in financial and currency markets. With the US PCE inflation hitting a 40-year high of 5.2 per cent in March, well above the Fed’s target of 2 per cent, the Federal Reserve appears to be in a hurry to arrest further price increase, especially with persisting global uncertainties set to maintain upward pressure on inflation. The Fed has, however, prepared the markets well in advance regarding its monetary tightening. Median projection of Federal Reserve Board members made in March, had pointed towards federal funds rate moving to 1.9 per cent by the end of 2022 and 2.8 per cent by the end of 2023. This means that another 90 basis points rate hike is likely over the rest of 2022. The Fed has also announced that it will begin reducing its balance sheet which has expanded to $8.9 trillion from its pre-pandemic size of $4.1 trillion. It plans to reduce the holding of treasury securities by $30 billion each month between June and August after which the reduction will accelerate to $60 billion per month. Similarly, the holding of agency debt and mortgage-backed securities will reduce by $17.5 billion for three months from June after which the quantum of reduction will double.

While the Federal Reserve’s move can help rein in demand in the US and reduce its outstanding debt, the impact on other economies may be far from benign. With over 50 per cent of global investors belonging to the US, low interest rates and surfeit of liquidity in the US have been fuelling global asset price inflation across markets. As rates begin to increase, especially at this rapid pace, capital outflows from riskier asset classes such as emerging market equity and debt will increase. A spike in US sovereign bond yields — the US 10-year bond yield is currently at 2.95 per cent — will also make portfolio money move out of emerging markets into dollar-denominated securities. Foreign portfolio investors have already net sold Indian stocks worth $17 billion and bonds worth $1.1 billion so far this calendar. The outflows are likely to persist if the Fed rate hikes continue. Indian stocks have been under pressure since the last quarter of 2021, as FPIs began pulling out money. Indian sovereign bond yields have had to contend with a high fiscal deficit as well as domestic inflation and rising global yields.

The rupee has been threatening to breach the 77 mark against the dollar. That the RBI is actively supporting the rupee through market interventions is evident from the sharp drawdown in forex reserves in the last several weeks. The central bank will have to continue this intervention to buttress the Indian unit. The 40 basis points hike in domestic repo rate will help stem outflows from Indian bonds somewhat, but more rate hikes may be needed to keep pace with global interest rates. Regulators should also try to encourage higher participation from domestic investors in equity and bond markets. That is the only way to truly insulate our financial markets.

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