The United States Federal Reserve acted in line with expectations when it raised the policy interest rate (the so-called Fed Funds rate) by 25 basis points (0.25 per cent) in its policy review last week. This was the third rate hike of 2017 and it was accompanied by an optimistic statement. The federal funds rate is now in a range of 1.25-1.50 per cent, which is still very low by historical standards. The Federal Open Markets Committee (FOMC) signalled that it planned to raise rates three more times in 2018, and twice in 2019. This was also the last FOMC meeting to be chaired by Janet Yellen, who is to be replaced by Jerome Powell in February. Ms Yellen has been noted for her dovish outlook. She leaves on a high note, with the US economy doing well, experiencing steady gross domestic product growth and job expansion. The FOMC projects inflation at 1.7 per cent through 2018, below its own 2 per cent target, and expects the unemployment rate to run at 4.1 per cent. The FOMC also estimates a higher GDP growth rate of 2.5 per cent, up from the October forecast of 2.1 per cent.
This rate hike was priced in and, as such, the financial markets barely reacted. The dollar weakened a little against the euro. There are “guesstimates” that Mr Powell, who also has a dovish reputation, will pitch for only two rate hikes next year. But he must cope with the possible effects of the Donald Trump Tax plan, which is due to be passed. That legislation could put billions of dollars back in the hands of US corporations and households even as it creates a larger government deficit. Another task will be to take a call on deleveraging the Federal Reserve’s huge balance sheet. The Fed bought lots of bonds during its long years of Quantitative Easing (QE). It is considering releasing those bonds back into the market. That could curtail liquidity by sucking money out of the financial system.
Many forex traders are also waiting for three other central bank meetings over the coming fortnight. There are hints that the Bank of Japan (BoJ) may taper its massive QE programme since the country has seen steady growth and some inflation in the past year. The European Central Bank (ECB) has already tapered its bond-buying but it may take a call on hiking interest rates, given that growth and inflation have risen across the eurozone. Finally, the Bank of England must negotiate an uncertain political environment; the pound has been hit by the confused Brexit narrative.
The impact of these decisions on India and other emerging markets will depend on several factors. First World assets are doing well — stock markets in the US, eurozone, and Japan are at multi-year highs. This could lead to money flowing back into hard-currency assets. A second factor is liquidity; if global liquidity is cut by tapers or rate hikes, traders will sell Emerging Market assets first. A third factor is Emerging Market growth per se — the First World boom could drive exports from China and India. When Ms Yellen took over from Ben Bernanke, it was a time when the US economy had just about stabilised after the subprime crisis. She chose to maintain a measured easy money regime. That enabled a “risk-on” attitude since it was emulated by the ECB and the BoJ. If global liquidity gradually tightens through 2018, that attitude will change.