From taper to rate hikes

From taper to rate hikes
As India gets deeper into a historic election battle, harsh external winds, mostly geopolitical, have begun to flow, compounding the economic and political challenges for a new government to assume office within two months. It remains to be seen how the new tensions in Europe over Ukraine, reviving cold war memories, play out in the coming weeks.

Meanwhile, the US Federal Reserve has, besides scaling down its monthly asset purchases as monetary stimulus since January 2014, begun to look at the time to determine when its near zero interest rate should begin to be raised. As and when the hike begins, it will have globalwide repercussions. A road map has emerged under the new Fed Chair, Janet L Yellen, who took over from Ben Bernanke on 31 January.

Accordingly, the Fed has come up with a revised forward guidance at the Federal Open Markets Committee (FOMC) meeting on 19 March, which advances the prospect of an earlier start of withdrawal of its five-year long near zero interest rate regime since the onset of crisis in 2008, than had been expected till the latter part of 2015 or 2016.

Such a reversal of the monetary accommodation could now begin to be made any time between the end of 2014 and 2016. Though there could be no immediate negative impact for countries around the world from its latest pronouncement, the Fed has virtually put nations on notice that the days of easy finance may be coming to an end sooner than what many had calculated. It would put the onus greatly on emerging economies like India where resilience had taken some knocks in the recent period.

Reactions in financial markets would be awaited.  In providing its ‘updated’ guidance, the Federal Reserve has sought to play down its significance by pointing out that there is no change in ‘policy intentions’ already known. The tapering process in the meantime continues and the FOMC has decided to reduce the monthly asset purchases by a further 10 billion dollars to 55 billion dollars from 1 April. The Reserve Bank of India which is to announce its first bi-monthly policy review on 1 April is expected to elucidate its own approach to the impending shifts in US monetary policy though, it is assumed, the first hike in US Federal Funds rate - the rate banks charge one another for short-term loans - from the present 0.0 to 0.25 per cent would not come through before end of our fiscal 2015.

The 2014 elections have created political uncertainty for an economy on a slowdown, and it has affected investments until after the post-poll situation gets clarified. RBI’s immediate approach would also be tentative until it could finalise a new monetary policy with CPI as benchmark at a target to be approved by the new Government/Parliament. Till then, the evolving trends in prices, production and exports would be under watch.

Despite faint signs of revival in the US economy, attributed to adverse weather conditions, the Federal Reserve now remains firmly on course in unwinding its asset purchases which had added trillions of dollars to its balance-sheet. The process will continue until the US unemployment rate, now at 6.7 per cent (February figure) comes down to 6.5 per cent and inflation in US is at least two per cent.

Current expectations are that by fall (last quarter of the year) the asset purchases would have been wound down and the unemployment rate then would be taken into account. But the Fed Reserve also insists on inflation which should not be below two per cent while It has been hovering well below that benchmark through 2013.  

In its statement, FOMC says it would look at a broad range of indicators - including unemployment, inflation expectations and financial developments - and readings on financial developments before determining on the first rate hike. Though it assumes it would be ‘considerable time’ between the end of tapering and a beginning in rate hike, analysts point out that the US central bank’s moment for withdrawing monetary accommodation has come ‘within striking distance’. The Fed’s mandate is maximum employment and price stability. But it has also kept the inflation target at two per cent. ‘The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run,’ the statement says.

But surveys of Fed officials released with revised economic projections by the Federal Reserve on 19 March suggest that after an initial hike, interest rates could move up more quickly than previously expected. Four officials believe rates could be at one per cent at the end of 2015, two more than in December. By the end of 2016, most survey officials believe rates could be two per cent or higher. In the Fed parlance, the normal level for interest rates is four per cent.  The Federal Funds rate, which was already on a downtrend since 2007, hit zero in December 2008. Such a magnitude of easing was designed to rescue the economy from financial market meltdown and economic recession. The stimulus (quantitative easing) helped to bring down mortgage and auto and other lending rates, and helped to boost recovery of the housing market and other segments of the economy.

While the rate of unemployment has remained elevated far longer than expected, despite the asset purchase programme, combined with the massive fiscal stimulus at the beginning of the Obama Administration in 2009, fiscal and monetary measures helped to create seven to eight million jobs till February 2014.

While the labour market may be healing somewhat, millions may have opted out of labour force. Some officials would favour keeping interest rates low until the economy is close to ‘maximum employment’ in line with Fed mandate. The other argument is that keeping rates low for too long could risk high inflation and financial instability.

Fed has lowered its forecasts for economic growth and on unemployment.  Growth in 2014 is now pegged at 2.8 per cent as against earlier three per cent, and down to 3 per cent in 2015 from 3.2 per cent. It expects unemployment rate to decline quickly to between 6.1 and 6.3 per cent this year and 5.6 to 5.9 per cent in 2015. The revised unemployment rates may have led the FOMC to revise its forward guidance on interest rates.

But the FOMC statement maintained that rates would remain at the current level, near zero, ‘for a considerable time’ after the Fed completes bond purchases, particularly if inflation remains stuck below two per cent.

Former Fed Chairman Ben Bernanke had said in December 2012 that interest rates would be kept near zero at least as long as the official unemployment rate remained above 6.5 per cent. Fed officials now say the forward guidance now given does not change the likely timing of a first rate increase. This is because unemployment may be falling more quickly but other indicators like inflation are sluggish. Inflation had risen 1.1 per cent in the twelve months ending January 2014 well below the two per cent target set by Fed.

S Sethuraman

S Sethuraman

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