Impact Analysis: Federal Reserve Cuts Benchmark Interest Rates

Impact Analysis: Federal Reserve Cuts Benchmark Interest Rates for the First Time Since the Year 2008: What Does It Mean?

Brief: The FOMC rate cut driven by externalities rather than internal macroeconomic conditions. Ems such as India must however be cognizant of any interest rate volatilities brought about by the Federal Reserve since maintaining an attractive yield differential is key to attracting foreign money

The US FOMC decided to cut interest rates by 25 bps for the first time in 11 years; consequently, the short-term interest rates stand between 2% and 2.25%. The US Fed fund rate has also shown signs of abating though not significantly. Rising by 2 bps since June, the interbank lending rate remains near the 2.35% level as on 31 st July (as per data available).

The decision comes on the back of concerns pertaining to the global economy and possible repercussions on the US. The trade war with China, middle east upheaval especially after the fall through of the Iranian nuclear deal have had significant impact on the global consumption, subsequently on trade. The IMF has already reduced its estimates for global growth and cited the fragility and recessionary tendencies instore.

Despite the global prevalent conditions, the US economy remains an oasis of macroeconomic stability and sustained growth. Q1 CY19 data reveals that the world’s largest economy grew by 3.1% as compared to 2.2% recorded same time last year. Overall, the US economy expanded by a robust 3% in CY18 in real terms, when much of the developed world was fighting recession and accompanied contraction. Other parameters such as inflation and low joblessness are also showing unabated signs of economic strength. While inflation remains near the 2% threshold, unemployment number is constantly undercutting even the 4% mark.

Global Concerns Behind the Move

Given these realities, it is evident that the FOMC’s decision to cut rates is not really driven by domestic concerns, rather it is driven by externalities that may derail the sustainability of the American growth story. Governor of the Federal Reserve, Jerome Powell stated that the rate cut was necessary to defend the US economy against the ill effects of the global slowdown, which is in turn hitting both US exports and consumption (imports). The rate cut was therefore justified as part of a ‘midcycle adjustment’ that will provide an impetus to businesses while keeping enough ammunition in case of a slowdown. While the Governor did not discount the argument of further rate cuts, he did not promise either. Therefore, while the market is anticipating at least 2 further rate cuts, domestic macros do not demand further such actions, as things prevail.

Repercussions on India

While emerging markets (EMs) such as India are themselves in a monetary easing cycle, ‘Fed tantrums’ cannot be ruled out. Indian Monetary Policy Committee (MPC) has cut rates twice back to back and is expected to ease further, given its accommodative stance. However, the recent rout in the equity and debt markets driven by FPI record sell offs spawns’ lessons to be learnt, especially when India is looking forward to attracting unprecedented foreign capital in order to fund its Rs. 100 lakh core worth infrastructure requirements. India must be cognizant of the fact that it must remain attractive to foreign yield chasing capital, which, at the moment is caring little about EM macro stability.

The capital markets are an interesting gauge to estimate the direction of foreign capital. The 10 year Indian and American GSec yield differential is currently hovering near the 470-bps threshold; a rate cut will diminish this differential by a further 25-35 bps at the onset. Comparable EMs such as Indonesia, Vietnam and Malaysia are offering higher yields and therefore a larger differential is available as an alternative to global hot money. While the US rate cut can be at best termed as a result of President Trump’s pressure tactics, Indian monetary policy makers must be aware of the repercussions and complications emanating from yield volatility.

Interest Rate

2018

2019

2019

2019

2019

2019

  Policy Repo Rate

6.25 

5.75 

5.75 

5.75 

5.75 

5.75 

  Call Money Rate (WA)

6.21 

5.78 

5.67 

5.62 

5.61 

5.59 

  364-Day Treasury Bill Yield

7.27 

6.16 

6.13 

6.06 

5.98 

5.98 

  2-Yr Indian G-Sec

7.57 

6.17 

6.18 

6.06 

6.10 

6.01 

  10-Yr Indian G-Sec

7.75 

6.93 

6.76 

6.56 

6.45 

6.62 

  10-Yr US G-Sec

2.95 

2.04 

2.12 

2.06 

2.07 

1.84 

  AAA (Indian corporate)

8.54 

7.95 

8.04 

8.30 

7.42 

7.76 

  Spread in bps (10 Yr Indian-10 Yr US)

480 

489 

464 

450 

438 

478 

  Credit/Deposit Ratio

74.93 

76.51 

76.34 

  USD LIBOR (3 month)

1.9173 

2.3549 

2.3564 

2.3590 

2.3606 

2.3504 

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