More than a year back, in December 2013 I had written an article titled “Don’t Fear FED TAPER for the right reasons” (http://www.sandipsabharwal.com/?p=974) . At that time there was extreme fear all around as to what will happen once the FED stops buying bonds from the markets. However given that the FED was taking the step due to the fact that it was no longer required and incremental benefit of the same was no longer positive enough for it to be continued and it was also inducing a sense of complacency in the bond market participants it was the right move. FED Tapered, ended bond buying and the markets continued to rally.
We are today in the same situation of the Fear of Fed tightening.
A central bank tightens policy under two circumstances.
1. The negative reason for tightening is that excessively loose monetary policy has lead to the formation of Asset Bubbles and high inflation and this forces the central back to hike rates. This is something that we saw in the US in the late 1980’s and early 1990’s in the Volcker era and in the Indian context both during the late 1990’s as well as after the 2008 crisis when there was a phase from 2010 to 2013 when inflation in India was out of control.
2. The positive reason for tightening is that the target of a looser monetary policy has been achieved i.e. growth has picked up, unemployment has gone down and there is greater confidence that the recovery will continue even if interest rates are higher. Inflation is well under control and unlikely to breach the comfort zone anytime soon.
Today when the FED Chairperson says that we will increase rates from, mind you ZERO percentage to 0.25% it is instilling a huge fear in the minds of people. This is mainly due to a lack of understanding of their actions. The reality is that as the bond buying was wound down by the US FED well in time they are starting the process of normalizing of monetary policy also well in time. Please understand, a good central bank is one which is proactive and not reactive. Already there are fears that excessive bond buying by not only the US FED but also the ECB and the Bank of Japan have created a bond bubble. A slow movement towards a normal monetary policy is not only desirable but also necessary as economic activity picks up and unemployment has gone down.
Now what happens in India due to the start of the rate hike process in the US. There is absolutely no need to be fearful. If inflation moves up in the US and is actually moving down in India is it necessary that just because the US FED increases policy rates interest rates in India will also go up? No it is absolutely not necessary and we will see this happen over the next two years. Inflationary pressures in India will continue to be low due to lower commodity prices which are driven more by Chinese slowdown rather than anything that is happening in any other part of the world.
US policy rates are likely to move up by 1% every year after the initial hike this year. As such if inflation does not pick up substantially in the US we will see the policy rates at 2-2.5% two years from now. Even these rates will not be restrictive for growth. Rates will need to go up much more before they start impacting growth negatively.
The story of India is that of
1. Economic Recovery- Which is well on the way in India and will only pick up pace over the next few months and year. Given the slack available in manufacturing capacities along with subdued input prices we are unlikely to see a pick up in manufacturing inflation any time soon.
2. Low Inflation- Raghuram Rajan’s policies have led to low inflation as well as low inflationary expectations for the future. The global scenario creates a situation where mild growth will keep inflationary pressures low. The only joker in the pack in India is always food inflation where also mild increases in Minimum Support Prices should keep this part of the inflation controlled. Sustained low inflation means low interest rates.
3. Improved Government Finances- Government revenues are seeing a strong uptick due to normalization of indirect tax rates. As economic activity picks up direct tax revenues will also pick up. With lower leakages, reduced subsidies, lesser corruption we should see the uptick in government revenues continue strongly. GST when introduced will also aid this process as well as push higher growth. An improved fiscal position of the government will lead to less crowding out due to the government and better liquidity availability for the private sector. This will also help the government push investments and aid economic recovery.
We are at the lower end of growth as well as earnings growth in India today. Recovery is around the corner and should sustain for a few years atleast. This is not the time to be fearful. Do not listen to the fear mongers. The time for fear will come but it is still a few years away. Equity is going to generate significant wealth for those who can look through short term events. Economic and Stock Market trends are long term and we are at the cusp of an upcycle. Do not fear the FED as long as they are doing the right thing.