As global central banks embark on a tightening spree, the debate on effect of monetary policy actions of developed economy central banks on emerging market economies is likely to resurface. The US Fed, the ECB (European Central Bank) and the BoE (Bank of England) members have all hinted at withdrawal of policy accommodation citing improvement in economic conditions and diminishing downside risks to inflation. The stark monetary policy divergence between the US Fed and other major global central banks is now fading, at least as far as recent commentary is concerned. It now remains to be seen which central bank will bite the bullet first as far as action is concerned, as there are risks associated with being ahead of the curve as well as being behind the curve. The only major central bank, which has not yet turned hawkish, is the BoJ (Bank of Japan).
Since for emerging markets like India, the US Federal Reserve policy spillover would be most crucial, we explore it in greater detail below.
Low inflation and wage growth have given the US Federal Reserve the comfort to hike rates gradually even when labor market is tight and S&P 500 is soaring. The US Fed has stated that the neutral federal funds rate (a rate which is neither expansionary nor contractionary) currently is lower than that in previous decades. One of the reasons why the wage growth is not picking up despite the low unemployment rate is that a significant number of jobs on offer are part time jobs that do not pay too well. The inability of the Trump administration to push through fiscal reforms has also given the Fed leeway in removing policy accommodation gradually. The dilemma before the Fed in removing policy accommodation is whether to do so by continuing to hike the federal funds rate or by beginning to trim its balance sheet size or use a combination of the two.
A recent speech by Fed member Lael Brainard explores the trade off between hiking Federal Funds rate and balance sheet trimming. While hiking the Federal Funds rate increases the short term rates, balance sheet trimming increases the tenor premiums and therefore the longer term rates. Hike in short term rates is known to cause more disruptive currency movements. Therefore as a result of hike in Federal funds rate, USD would appreciate more and for an emerging economy like India, it would be disruptive on two counts. Firstly it would stoke imported inflation (imports become more expensive as Rupee depreciates) and secondly depreciation of Rupee would boost exports and therefore domestic demand driven inflation (i.e. increase demand for goods used as raw materials for exports). Therefore in this scenario the emerging market central banks would be more hawkish and reluctant to cut interest rates. If the US Federal Reserve were to withdraw accommodation only by trimming its balance sheet size, it would be less disruptive for emerging markets like India as USD would not appreciate to that extent. Therefore the emerging market central banks can afford to be less hawkish.
As things stand currently, the Fed seems keen in hiking Federal funds rate to a level away from the effective lower bound (ELB) from where it can cut rates if economic conditions deteriorate later. Therefore it is likely to use Federal funds rate as the primary monetary policy adjustment tool. Given that wage growth, latest June core CPI and Retail sales prints have been below estimates, Fed can afford to hike rates gradually.
This means that August would be the best opportunity for the RBI to cut the repo rate by 25bps as Fed is not hiking rates aggressively. Given that domestic core CPI is below 4% (i.e. at 3.98% which is within RBI’s comfort zone) and industrial activity as indicated by May IIP (0.9%) is tepid, domestic factors too are supportive of a rate cut. 1 month OIS (at 6.19% as on 14th July) is currently pricing in a 65% probability of rate cut on 2nd August*.
The fact that US Federal Reserve policy influences RBI actions is evident from the surprise OMO sale announced couple of weeks back when US 10yr yields spiked from 2.10% to 2.30%. The announcement of OMO sale was intended to push domestic bond yields higher so as to prevent outflows. Also, sucking out liquidity allows RBI to intervene in currency markets to absorb inflows, if needed, without infusing excess liquidity into the system. The RBI currently seems content allowing the Rupee to perform in line with Asian currencies and curbing intraday volatility. The realized volatility has been less than implied volatility for quite some time now. Over the last fortnight, price action suggest that the central bank has been mopping up USD and swapping them forward. The 1 year annualized forward premium has risen from 4.51% to 4.65% over the period. After the weak US CPI and Retail sales data on Friday, the US Dollar got sold off across the board. It seems the Rupee would spend some more time in 64-65 range and USD bulls would have to be patient a while longer.
* The probability of rate cut is derived from 1M OIS as follows. RBI policy is on 2nd August. As on 14th July there are 19 days left to the policy. In a one month fixed for floating swap indexed to repo, one would get 6.25% for 19 days and [p*6%+ (1-p)*6.25%) for the remaining 11 days (6.09% at p=0.65, i.e. the current probability). The 1M OIS is the weighted average (i.e 19*6.25% + 11*6.09% =6.19% i.e. the current 1M OIS)