Arshad Shaikh looks at the biggest interest rate hike announced by the US Central Bank (popularly known as the Fed which stands for the Federal Reserve) and its possible economic consequences for India. Experts point out that our policymakers will have to keep an eagle eye on the financial conditions, our trade deficit, domestic consumption and the worsening inflation along with the fall in the rupee. The RBI has its work cut out in the coming days. We also need to think out of the box and explore different approaches to regulate the economy besides the conventional tools at our disposal.
The Fed Chairman, Jeremy Powell recently announced a 75 basis point (0.75%) rate hike in the fed funds rate. This is the sharpest hike since 1994. One of the key objectives of the Fed is inflation targeting (the current target is 2%). The opening of the floodgates by the Fed to keep the economy afloat during and after the Covid-19 pandemic by injecting nearly 5.7 trillion dollars and maintaining the interest rate to near 0% since early 2020 resulted in an annual inflation rate of 8.6%, a 40-year American high. The Fed had no choice but to raise the interest rate notwithstanding the challenges it posed to the American as well as the global economy.
Powell spelled out the Fed’s objectives saying, “We’re not trying to induce a recession right now, let’s be clear about that if you were to get inflation on its way down to 2%, and unemployment up to 4.1%, that’s still a historically low level…3.6% is historically low in the last century. So a 4.1% unemployment rate, with inflation well on its way to 2%, I think that would be a successful outcome.”
So much so for the Fed and the American economy. But we all know that things are not so simple and inconsequential in a highly-connected global financial system. The international bond and equity markets compete for funds that have a direct bearing on the investment and growth prospects of different countries especially emerging economies like India. Hence, the Reserve Bank of India (our Central bank) has its work cut out.
Since it has also tasked itself with inflation targeting, the RBI has to navigate its monetary policy to ensure price stability, manageable trade deficit, stop the fall of the rupee as well as calm the markets with an impending flight of foreign capital. A tall order that will test the RBI’s money-management skills to the limit.
We also need to start thinking out of the box and explore ideas beyond the limited toolkit deployed by Central banks to confront similar situations. If interest rates in a particular country have the power to ruin another nation’s economy then that is not a healthy situation and needs to be addressed and nullified, even if it entails embracing heterodox ideas.
A cascading effect of monetary policy in the United States leads to what is known as the ‘carry trade’. Emerging economies such as India experience rapid economic growth compared to advanced countries such as the US and other Western European countries. Hence, they tend to have higher inflation and higher interest rates. The rates of interest in countries like the US and Japan have been very low or near zero.
Naturally, the Foreign Institutional Investors (FIIs) prefer to borrow money in the US at low interest rates in dollar terms and then invest their funds in equities and government bonds of emerging countries like India in rupee terms to earn a higher rate of interest. Thus, we have a positive stream of foreign portfolio flows into the Indian stock and bond market. This is known as carry trade and is in many ways responsible for the boom in our equity market.
If rates of interest in the US start increasing, the carry trade is reversed. FIIs will stop finding Indian bond markets lucrative and may withdraw their funds from Indian G-secs (government securities) to reinvest in the US gold and treasury markets.
This reverse carry trade has two effects. One is that it may cause a flight of funds from emerging markets or a global sell-off leading to a bearish market and depletion of a positive investment climate. To stem the flight of funds the RBI will be forced to increase interest rates but this will only reduce the domestic credit offtake, lowering investment and hence growth and development.
Secondly, the Fed hike will also affect the rupee. As interest rates for dollar-denominated securities begin to move northward, the demand for US dollars will increase making it appreciate against the rupee, which may fall further. This will also impact our trade deficit negatively.
RBI TO THE RESCUE
The challenge of increased fed funds rate has to be met with fiscal and monetary policy tools to ensure macroeconomic stability. RBI will have no choice but to keep raising its benchmark repo rate to maintain the differential between the rates of India and America. An increased repo rate (the interest rate at which commercial banks borrow money for the short-term from the RBI) is like a disincentive and reduces the loan offtake from the RBI.
The money in circulation reduces and cools the economy with a reduction in inflation (defined as more money chasing fewer goods). With a reduction in consumption, there is a corresponding increase in saving. By increasing interest rates, the RBI tempts investors to buy government bonds and other fixed-interest products.
This also aids in reducing the money in circulation. On the fiscal side, the government Overall government expenditure and transfer of payments are decreased. An increase in taxes also accelerates the reduction in the money supply. In short, the government must aim to reduce its expenditure and increase its revenue.
The real problem that frequently disturbs the economies is not the volatility but the intrinsic concept of present-day banking itself. Allowing an institution to create new money and lend it to the market by charging interest, is fundamentally wrong both from a moral and economic perspective.
Handing over the reins of the supply of money to these institutions (banks) that have created a financial system operating on the principles of “fiat money” and “fractional reserve banking”, gave them a free hand to design a system that has connected economic growth to the growth of credit, with disastrous consequences. This has led to problems of inflation, deflation, stagflation, and a boom and bust economy (based on business and credit cycles).
Today some of the most advanced economies of the world have been reduced to a state in which their banks are offering “zero” or “negative” interest rates and yet there is no credit offtake with negligible GDP growth.
Moreover, this free money or helicopter money floods the money markets; it creates bubbles in the stock markets and real estate inflating prices artificially. When the time comes, interest rates are adjusted with disastrous consequences for the world. Just as a taboo has been created around the “mixing of religion with politics”, similarly the role of the government is loathed by the banking fraternity to regulate and rectify their wider operational philosophy and framework.
The stability of our monetary regime and economic system should definitely be preserved, but with a new set of rules. It will be a huge tragedy if the Islamic concept of “interest-free” banking and “equity-finance” is neglected by those who control the levers of power and influence. When the going gets tough, the tough get going. But it’s time to think and go heterodox.