Monday November 30, -0001

Executive Briefings Politics & Economy: Currency And Markets

This is only the beginning

Analysts agree that US interest rates will hover around 4.75% to 5% by March 2023. Inflation seems tohave become stickier than what Federal Reserve officials may have previously expected and so, ratehikes will continue. Jerome Powell, the Fed’shead has clearly stated that until inflation falls, his taskremains unfinished. Theproblem for Mr Powell arises from the generous spends by the USadministration. The USD 2 trillion package approved by Congress, on the recommendation of theWhite House, will create demand pressures and in the absence of rising supplies, prices will continue toharden. Manufacturers take much longer to expand capacities than governments do to spend money.The real issue is that a lot of these funds, whilst having been allocated, are yet to be spent by variousstates in America. When they spend, they will add to demand and so to higher prices. Worsening thesituation are handouts and tax rebates offered to ease pressures of higher living costs on households.California, for instance, is depositing USD 1,300 in the bank accounts of tax payers. Several other stateshave taken recourse to similar pranks, including tax rebates. Consequently, the impact of higher interestrates on demand stands negated. Basically, in America and elsewhere, fiscal and monetary policies arepulling in opposite directions. This is bad news for the rest of the world.

One impact has been the depreciation of all major currencies against the US dollar. The Euro is literallyat parity and the pound has been hammered in recent weeks in the forex markets. Clearly, some of thiswas the result of unfunded tax cuts announced recently by the British government, which received ablatant thumbs down from bond traders who dumped the sterling. Had the Bank of England notintervened, the fall in its value would have been worse. Emerging markets too have taken a hit but sofar seem to be hanging in. However, this is only the beginning and things will worsen before theystabilise. Every percentage rise in US interest rates has an exponentially greater impact on currencymarkets and interest rates across the world. Therefore, the months ahead will prove exasperating.All of this has worrying consequences for India’s economy and local companies. The fall in the rupee’svalue has been in line with the yield spreads between US treasury and Indian sovereign bonds. As thesenarrow, investors will dump Indian paper scrambling to the safety of the dollar and to better returns inrisk free instruments. In 2008, the spreads were thin and the rupee lost almost a quarter of its value. Onthe other hand, in 2011 when they were broad, the rupee held ground and in fact strengthened. Bondspreads now stand at 3.44% versus 6.89% in May 2011. This is not nearly enough to incentivise foreigncapital flows into India and so the rupee will continue on its downward slide. At this time, it is hard todetermine what the floor may be.

The Fed, having botched up its monetary policy some months ago when the first signs of inflationbecame obvious, is now determined to do what it takes to bring it down. Its hawkish stance willtherefore remain. Clearly, this comes with a flip side as higher fund costs will almost certainly trigger arecession in theworld’s largest economy. Chinais hell bent on pursuing its zero covid policy, with littleregard for economic implications,and that takes two of the world’s largest markets into a slump. Mostadvanced economies and some emerging markets are likely to follow. India may yet escape a full-blownrecession but demand may moderate as costs rise, savings in financial instruments lose value and createanegativewealtheffectphenomenon.Businessesshouldthereforetweakstrategiesthatarecomplimentary to this situation. Margins and stability should over-ride growth considerations.