Impact of Federal Reserve's Decision on India

Why India was Indifferent? 18 SEP, 2015

Burning Desires- Desire to earn, not burn

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“Burning Desires explains why

India was Indifferent from Federal

Reserve’s Decision as to whether

raise or hold the Interest Rate”

Burning Desires

Why India was Indifferent?

Considerations

This article is also uploaded on Scribd and Slideshare.net for readers’ future

reference.

It covers the dynamics behind US Federal Reserve’s decision as to holding the

interest rates

India was Indifferent means; The Indian Economy was under win-win situation

irrespective of Federal Reserve’s decision, Why of the same is the main theme of this

article.

What all It Covers?

Pg. 01

Burning Desires towards Value Investing

Every Central bank of a country, while formulating stimulus package or monetary

policy, used to have various agendas on the table.

Like past month in India, while RBI decided not to reduce the interest rate because of

certain criterions not being achieved or not under control.

What are they?

First being rainfall

India measures rainfall on the basis of LPA (Long Period Average) in which we

consider average rainfall in past 10 years. In the current year, we have achieved only

88% of LPA rainfall, which will further boost the food inflation and thus CPI. So, here

Inflation was questioned.

Second being Interest Rate Transmission

Since the Inflation came under control, RBI have been reducing interest rate by 25

bps (0.25%) each time for trice and total Interest rate gone down from 8 to 7.25%.

But out of this 0.75% reduction in interest rate only 0.30% have been passed on to

consumers by bankers. Which is indeed not fair, Isn’t it?

It’s because, if the interest rate reduction benefits have not been passed on to the

consumers, the whole purpose of reducing the rate fails.

So, that was the agenda that RBI was having in mind while not reducing the interest

rate before Average rainfall is not achieved and full transmission of interest rate is

not passed.

Now, let’s look at the agenda that US has and why Indian Stock market won’t be

impacted because of Federal Reserve’s Decision.

Rainfall and Interest

Rate Transmission

was RBI’s Agenda

and depending on

the context of a

particular country,

Inflation rate and

Inflation rate healthy

numbers differs. Like

In case of India, 4 to

6% inflation is

believed to be a

healthy one whereas

its 2% in case of

United States. There

is no universal figure

set that it is believed

to be a healthy as far

as Inflation and

Interest Rates are

concerned.

Pg. 02


Before getting into the topic, we should understand that US Fed was more likely to

raise the interest rate when the rate-setting committee last met in June. But, things

are looking better (Unemployment rate and GDP Forecast) than it was in June and

that is why the opposite decision is taken as to holding the interest rate till further

improvement does not takes place.

As for US, the Fed committee’s median growth forecast for 2015 has risen from 1.9%

to 2.1%. Unemployment has fallen faster than expected, to 5.1%. But with the

inflation outlook weakening, the Fed chose not to rush into a rate rise. This was the

right choice. But the longer the Fed holds off in the face of strong jobs data, the

tougher its communication challenge will become.

Global economic weakness has brought down the Fed’s inflation forecasts.

Commodity prices continue to fall, while the relative strength of the American

economy means the dollar has strengthened, depressing the price of imports. On

the Other hand, Janet Yellen, the Fed’s chairman, thinks those trends will be

transitory. The same situation that RBI Governor also faced and that is the reason

why Mr. Raghuram Rajan was hesitating to reduce the interest rate because of its

being transitory.

(As per Burning Desires’ analysis,

Reduction in inflation does not matter in absolute numbers. What matters is how

long the reduction in inflation is sustainable? So, Mr. Rajan first checked out the

feasibility and for the initial three to four months when inflation started reducing,

he decided not to reduce the interest rate despite undergoing too much pressure

from Finance Ministry and Arun Jaitley.)

Why there was a

turnaround in the

decision?

Ms. Yellen

(Chairperson Fed)

and RBI Governor

faced the same

situation.

Agenda on the Table

Improvements in

the Labor Market

&

Inflation rate at 2%

Pg. 03


Ms. Yellen said she will continue to look for further improvement in the labor

market, which would spark confidence that inflation will eventually pick up. In

particular, she emphasized that many part-time workers are still looking for full-time

jobs. Rate-setters’ estimates of the sweet spot for unemployment, below which

inflation should pick up, also fell a little.

What does it mean- Burning Desires simplifies it.

Improvement in Labor Market means decrease in Unemployment rate. This follows

from a conventional model of the economy that says a tight labor market leads to

inflation later on, as firms bid up wages and then raise prices to offset the cost. So

strong has Ms. Yellen’s emphasis on the labor market been that some analysts

thought August’s jobs numbers were all that mattered for Fed’s decision. But the

world economy is throwing a spanner in the works of this model. In the committee’s

median forecast, inflation does not return to target until the end of 2018, despite

three years of near-equilibrium unemployment.

If the world economy continues to weaken, the Fed will need an ever-tighter

domestic labor market to meet its 2% inflation goal.

Why main agenda

being Improvement

in Labor Market?

Ms. Yellen would

then find herself

demanding “further

improvement” in

the labor market

every month, even

in the face of

repeatedly strong

labor market data.

That would be a

confusing message

for markets,

especially if

unemployment falls

beneath the Fed’s

own estimate of its

long-run

sustainable rate

and broad measures

of

Pg. 04


Is it a wrong Decision?

No. Burning Desires Explains Why?

Thus Federal Reserve’s focus on the labor market, then, does not mean that the Fed

is ignoring the world economy. Quite the opposite; the gloomier the world outlook,

the stronger the labor market must perform to justify a rate rise. In the coming

months, markets should look to the world, as well as the jobs data, to predict when

interest rate should be raised?

Now, looking at Impact on India,

The saturation in China will positively result into capital inflow in India as China has

no longer remained a safe bet.

Indeed, China’s US debt holding makes it a Powerful negotiator with US as compared

to India but India has already surpassed China as a global growth engine as far as

Emerging economies are concerned.

So, if Fed increases the interest rate how would India Benefits?- Burning Desires

Simplifies it as follows.

A higher US interest rate or expectation of that will definitely have some impact on

emerging markets in the form of capital outflows. So, yes, we may have seen some

correction in emerging markets including India.

“Now for India, the economic situation is much better than it was 2-3 quarters ago.

India has taken some of the major steps compared to its Emerging Market peers to

control currency movement and increase foreign exchange reserves.

Strong

Fundamentals are

at Place in India

now.

If Correction

comes in the stock

market it’s not

always bad as it

gives the

opportunity for

fresh investment

and further capital

Formation.

Pg. 05


Only in recent past the Indian market hit an all-time high. So corrections would have

been there definitely be there, but not as much as we have seen in 2013 as

fundamentals are better now.

Although it would have taken the US Fed some time to shift from its zero interest rate

policy, but if they do that, there may be a kneejerk reaction wherein some hot money

may try to get out.

On a totality basis, India is possibly the only market in the emerging market basket,

where a 15 per cent to 20 per cent earnings growth is reasonable to expect and the

economy recovery looks robust with GDP move from 5 per cent to 7.5 per cent in

three to five years’ time being almost a surety. There are a lot of positives for India

right now than the negatives. However, you might see some healthy corrections

coming in when the markets start consolidating again. The overall trend of the market

looks quite positive and given the fact that the markets have run up in the last three

to four months, a correction is indeed healthy as it will give opportunity for fresh

investments.

Economy & Finance

Impact of Federal Reserve's Decision on India