Is India insulated from US Fed rate hike?

The prospect of a rate hike by Fed at its next Federal Open Market Committee (FOMC) meeting to be held on September 17 at Washington DC is most likely, after the July job reports indicating a robust growth.

The Federal Reserve was expected to raise the Fed Funds rate by 25 basis points (bsp) at the FOMC meeting on July 28, but then it did not since the financial markets were still unsettled after Brexit.

Wall Street, after an initial reaction, has since calmed down by the dovish tone of US Federal Reserve governor Lael Brainard's speech in Chicago, even as the global markets have gone tumbling already early last week.

The rate is now between 0.25 per cent and 0.5 per cent. The Fed raised the rate last at its December 2015 meeting, which was the first ever increase since June 29, 2006.

The above rate had been virtually kept at 0.0 per cent to 0.25 per cent between 2006 and 2015 to combat recession and since maintained at 0.25 per cent to 0.5 per cent due to stable conditions of the US economy.

Once the Fed raises the Fed Funds rate, it will probably go up by 0.25 per cent at first and then it may rise not beyond two per cent. This is because inflation is not a threat anymore.

There can be possible knee-jerk reactions among domestic traders and investors at first, which may lead to drop in the Sensex and the value of rupee, as domestic markets open for trade on Friday.

If the Fed hikes rates, some foreign investors are expected to book profit of their Indian holdings of shares and bonds.

They may repatriate funds back to the US, where buying high interest rate bearing bonds will be attractive. They may offload masala bonds also in preference to US bonds.

Selling by foreign investors has a large impact on the Sensex and Nifty as they own shares in the blue chip segment, which constitutes nearly 25 per cent of the BSE, ie 200 shares, says a recent report.

The prospect of a rate hike in the US, led foreign investors to sell equities. This may lead to corrections in the Sensex.

But, did the Fed have another goal in mind? It appeared to be taking steps to get the economy out of a classic liquidity trap. That's when families and businesses hoard cash instead of spending it. Low interest rates don't give them much incentive to invest cash.

There's a psychological reason, too. The Fed has talked about raising rates for at least a year. In response, forex traders expect the dollar's value to rise.

To take advantage of that, they are shorting the euro. That has strengthened the dollar by 25 per cent in the 2014 and 2015. The strong dollar hurts exports and slows economic growth.

Further, strengthening of the US dollar will hurt American exports more and slow their economic growth further and will create lower import prices and thus, reduce inflation.

Purchases might cost less in future. So, the Fed will definitely raise interest rates to find a way out of a possible liquidity trap whereas the same in India will mean a weaker rupee leading to a fat import bill for India. We are already importing 80 per cent of oil to cater to our fuel needs. Our consumer price index (CPI) has major component as fuel and if our import bill rises, it is feared inflation rate may also shoot up.

Now, the rupee could hit a low of 66.00 to 66.46 against 66.73. Earlier in August rupee had shed four per cent since August from 64.13 to 66.46 already and had bounced back after correction.

The impact of a rate hike in the US on India will be limited because of strong fundamentals as a tidy repo rate structure, inflation targeting and tight money control by the Reserve Bank of India (RBI).

A record high of current account deficit, double digit inflation and record low rupee are all over and stories of the past. The new tax reform is a big revenue boost and a new engine of growth supposed to forestall all possible global impacts such as Brexit, Fed rate hikes, oil prices or any global downtrend.

Let us wait and watch how the Fed's announcement impacts Dalal Street. A rate hike if any which would be for the first time in close to a decade now is expected to go well with Wall Street market and as well as across markets world over.

Always something new will pop up on the horizon like Fed rate hike, oil prices, devaluation by China and there will also be talks going on everywhere.

But, that India will strike its own balance under the prevailing global economic conditions is everybody's hope, especially with a new tax reform and a good monsoon in sight and in addition a strict fiscal discipline maintained by the Reserve Bank for the country.

Also read - How US Fed rate hike could impact the Indian economy