WORLD MONEY
The US Federal Reserve delivered its expected quarter point hike in interest rates last Wednesday. Currency markets did respond to the Fed move despite the claim by many analysts that it was all “priced in” earlier, although nowhere as vehemently as during the taper tantrum of 2013. The US dollar gained against a number of G-7 currencies like the Euro as well as a basket of emerging market currencies. On the whole, the Fed successfully portrayed itself as serious about unwinding liquidity at a steady pace without an adverse market reaction. One should remember that Ms Yellen’s tenure will come to an end in February 2018 and it is important for her to establish her credibility as a tough monetary boss.
The fact that the Fed stood its ground, hiked the rate and seemed reasonably convinced about another rate hike during the rest of the calendar year seemed to indicate to markets that the Fed was in a “hawkish” mode. Besides, the clarity on liquidity withdrawal (that is the reversal of Quantitative Easing) appeared to have strengthened this view. For a currency like the USD that has been mercilessly beaten down over the last few months, this was reason enough to spur buying. This pushed the dollar up against a number of currencies and led the much-tracked dollar index (a basket of key exchange rates against the dollar) to climb up quite a bit from around 96.5 before the Fed announcement to close to over 97.5, a respectable gain by any standards. The rupee too lost a fair bit and on Friday morning crossed the 64.70 mark.
While Fed Chair Yellen indicated that the Fed remains confident about inflation rising to its target of two per cent over the medium term bolstered by a robust labour market many questions about the performance of the US economy continue to remain unanswered. For example, why has inflation remained weak even as the unemployment rate has fallen for successive months? Is the performance of the US economy indeed improving as indicated by the fall in the unemployment rate? The data print on growth has been disappointing so far while hopes for a fiscal stimulus are waning, as the political scenario is making it difficult for the administration to move forward with concrete policies.
Coming to the labour market conundrum, it is hard to explain why the unemployment rate has been falling steadily but there are no signs of acceleration in wage growth. A possible explanation can lie in demographic factors which have brought down the natural rate of unemployment (the rate at which inflation goes into a steady state, neither accelerating nor decelerating). This means that even with tightening labour market conditions, inflation pressures could remain soft putting the Fed in a perpetual dilemma.
So why did the Fed not only raise interest rates but also maintain its forecast of one more rate hike this year to be followed by three in 2018? The real reason may be to move ahead in the task of normalising monetary policy from a long period of extreme accommodation which outweighs any concern over recent economic data falling short of expectations. To this end, the Fed also laid out its plan for a steady reduction in its assets starting towards the end of this year. While the Fed has been extremely cautious on the planned reduction, the liquidity drain is bound to have an impact on asset prices going forward.
The rupee, which had appreciated significantly since the beginning of 2017, initially reversed direction much to the relief of those worrying about its competitiveness. The rise in India’s trade deficit during April-May on the back of higher imports further supported the fall in the rupee. India’s current account deficit is likely to widen this year.
By Friday evening however, the initial bang in the dollar index had turned into a bit of a whimper as the dollar index lost ground and the rupee moved back to 64.40. However, it is too early to write the dollar pop as a flash in the pan. Sudden reversals and rallies typically induce some desperate selling action that put a brake on these sudden movements. However, if there is a fresh round of gains in the dollar index, it might mean some weakness in the rupee going forward.