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India Monetary Policy: U.S. Fed Delayed India’s Exam, Didn’t Cancel It

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As we await the decision from the December monetary policy review, much has been said about the turn in oil prices and consequently the fortunes of the Indian currency. But there has been another important development between the October and December policy reviews – an apparent change in the outlook for rate hikes from the U.S. Federal Reserve.

Jerome Powell’s speech on November 28 at the Economic Club of New York was interpreted somewhat exuberantly by markets around the world, including India. The U.S. Federal Reserve chairman was seen as implying that the Fed may be slowing down the pace of its proposed rate hikes. The yield on India's 10-year government bond—which started November 2018 around 7.8 percent—fell to 7.61 percent.

Over the last couple of months, the Indian market had betraying signs of nervousness, with the 10-year hitting 8 percent at the end of September. The prospect of lower U.S. interest rates lasting for longer added to the cheer brought on by lower oil prices.

Is this likely to be lasting relief? Or is it akin to an under-prepared student celebrating when an exam is postponed? But just as the exam eventually comes round, it can be argued that the U.S. rate normalisation has, at best, been delayed.

In his speech, Chairman Powell did not say anything about changing the guidance on rates.

The Fed had previously provided a guidance that the Fed Funds Rate was targeted to reach 2.5 percent by December 2018, 3.0 percent by 2019, and 3.5 percent by 2020. That would test the fiscal and monetary strength of emerging markets.

U.S. Federal Reserve Chairman Jerome Powell at the Economic Club of New York, on Nov. 28, 2018. (Photographer: Mark Kauzlarich/Bloomberg)

Also Read: U.S. Fed A Central, Not Peripheral, Factor In Future MPC Moves

Deciphering Powell-Speak

  • On Oct. 3, Powell said the Fed is “a long way” from getting rates to neutral.
  • On Nov. 28, he said rates were “just below” the range of estimates of neutral.

A ‘neutral rate’ is defined as the interest rate that neither accelerates, nor obstructs economic growth. The Fed estimates the neutral rate to be in the range of 2.5-3.5 percent. The current rate is 2.00-2.25 percent.

"To that extent, the market’s reaction possibly calls for a rethink, since a rate of 3.5 percent, which is the target rate of 2020—and 125-150 points away from the current rate—is very much a rate in the neutral zone."

So, one can argue that the Fed may continue on its upward trajectory.

The market consensus expects one hike this month, and a 50 basis point increase distributed over 2019. The market currently expects the Fed rate to be 2.50-2.75 at end-2019 as opposed to 3.0-3.25 percent that was previously guided. Note that several prominent analysts, however, have maintained their expectation of an increase of 100 basis points over the four quarters of 2019.

As of now, neither doves nor hawks are predicting a recession in the immediate future, which would have made the Fed stop its upward trajectory altogether.

India’s Trial Merely Delayed, Not Cancelled

This is where the Indian bond and money markets, as well as the regulators need to be careful. A Fed Funds Rate of 3-3.5 percent is still likely to play out over 2020-21 (if not over 2019-2020 which the author believes).

The directional implications of U.S. rate hikes on emerging markets are many.

  • A rise in U.S. rates is likely to result in meaningful global portfolio re-balancing, with money flowing out of emerging market assets to U.S. assets.
  • The capital flight then causes weakness in emerging market currencies, such as the rupee.
  • Net-importers of capital and commodities like India may then see higher domestic inflation as well as pressure on the current account.

It is timely, then, to assess what interest rates in India may look like, if and when the Fed rate crosses 3 percent.

RBI Governor Urjit Patel,at a news conference in Mumbai. (Photographer: Dhiraj Singh/Bloomberg)

Also Read: Bond Bulls Return to India to Fuel Best Quarter in Over Year

India Rate Scenarios

The rate differential, also called the spread, between the U.S. 10-year yield, and India’s 10-year yield is driven by a number of factors. These include the inflation rate differential, credit premium, liquidity premium, and transaction costs and taxes. Modelling all of them is beyond the scope of this piece.

By studying the spread of the U.S. 10-year yield over the U.S. Fed Rate, and the spread of the India yield over the U.S. yield--over multiple decades, and suitably moderating for the prevailing economic conditions at the time--one can arrive at a range of possible values for India’s yield, with a U.S. Fed Funds Rate of 3-3.5 percent.

In line with the real yield differential, the differential in the nominal spread of India rates over U.S. rates has been on the rise.

  • Prior to the global financial crisis of 2008, the India yield was, on average, 3.5 percent higher than the U.S. yield.

(India-US Spread Chart)

  • Post-2008, this number averages around 5.4 percent.
  • In the last 12 months, it hovered between 4.6 percent and 5 percent.

Domestic inflation, currency weakness, and higher perceived credit risk may result in this spread widening.

Five years ago, when the economy was under stress in 2013, this spread ranged from 6.0 percent to 6.6 percent.

Meanwhile, the U.S. 10-year yield has held around 0.75 percent to 1 percent over the Fed rate.

If relative economic conditions in India and the United States remain roughly unchanged, (at the risk of being over-simplistic) it’s possible that a 3 percent Fed rate may translate to an India yield in the range of 8.35-9.00 percent.

An India yield of 9 percent was last witnessed in 2001. In 2013, the yields came quite close to the 9 percent mark. Arguably, if India maintains its monetary and fiscal house in order, even in the event of even a 3.5 percent Fed rate, Indian yields can be held below 9 percent.

"However, in a 2013-like scenario of a challenging monetary and fiscal situation, where India is unprepared for this move and the spread breaches 6 percent, then a 9 percent yield becomes a possibility."

P Chidambaram and Pranab Mukherjee, with Manmohan Singh. (Photographer: Pankaj Nangia/Bloomberg)

Also Read: Bonds Face Barrier in India as Banks Sell Into Every Rally

Can’t Let Down The Guard

Currently, India’s monetary and fiscal fundamentals are, beyond doubt, better than they were in 2013. However, the ‘confidence’ about this strength, in certain quarters, may have overtaken the on-ground reality.

Let us remember the pre-crisis period of 2007-2008. With the rupee strengthening past 40 to the dollar in 2007, certain sections were considering whether the RBI was holding too much foreign currency reserve. Ideas were floated on using the foreign currency reserve for funding India’s infrastructure. Sound familiar?

  • Between May and December 2008, India’s for exchange reserves dropped by over $70 billion in firefighting the global crisis.
  • Between May and September 2013, forex reserves fell by around $22 billion due to the ‘Taper Tantrum’.
  • Between April and October 2018, the reserves dropped $32 billion at a time when the RBI was merely trying to ‘reduce volatility’, and was not targeting a dollar-rupee level.

So is this the right time to be adventurous about RBI’s reserves?

To come back where we started, a further 75-125 basis point hike by the Fed is still within the ‘neutral zone’. Here’s the worry then. In the circumstances that India’s financial health is unprepared for the move, a jump in the Indian yield towards 9 percent would force the RBI’s hand on a tightening cycle that would be much longer than anything the market is currently anticipating. To prevent that from happening, use the opportunity provided by this month’s meeting of the RBI’s central board, for the government and the RBI management to commit to a list of common benefits: robust reserves, benign inflation, fiscal discipline, and a close eye on indiscriminate overseas private borrowing. Not new goals, but ones that need re-affirming.

Deep Narayan Mukherjee is a financial services professional and visiting faculty of finance at IIM Calcutta.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.

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