The meeting of the Federal Open Market Committee was held on December 14, 2004. Following are the key excerpts from the minutes that were released this week (in italics). We highlight the implications of the same on the Indian stock markets.

1. On the recent US economic performance: The economy expanded at a moderate pace over the third quarter and into the current quarter. Consumer spending was solid, and investment spending remained strong. Core inflation measures remained subdued, albeit running at a slightly higher pace than last year, owing, in part, to the indirect effects of higher energy price.
   
   

2. On consumer spending next year: With economic activity projected to expand at a pace a little above that of its longer-run potential over the coming year, hiring was projected to continue to firm, causing the unemployment rate to edge down next year. The steep run-up in housing prices, recent increases in equity prices, and anticipated gains in payrolls were viewed as likely to boost the growth of consumption spending next year to a pace somewhat above that recorded this year.
   
   

3. On the business investment outlook: Business investment was anticipated to decline a bit early next year in light of the expiration of the partial-expensing tax provision at the end of 2004 but was projected to resume vigorous growth in response to a favorable economic outlook, supportive financial conditions, ample liquid assets in the corporate sector, and an ongoing need to replace or upgrade aging equipment and software.
   
   

4. On inflation: A number of participants cited the recent depreciation of the dollar on foreign exchange markets, elevated energy costs, and the possibility of a slowing in underlying productivity growth as factors tending to boost the upside risks to their inflation outlook, though, on net, they saw the risks to stable underlying inflation as still balanced.
   
   

5. On interest rates: In their discussion of financial market conditions, participants noted that investors anticipated further increases in the federal funds rate over the coming year, but intermediate- and long-term interest rates along with financial conditions more generally had remained quite supportive of growth.
   
   

6. On liquidity and speculative demand: Some participants believed that the prolonged period of policy accommodation had generated a significant degree of liquidity that might be contributing to signs of potentially excessive risk-taking in financial markets evidenced by quite narrow credit spreads, a pickup in initial public offerings, an upturn in mergers and acquisition activity, and anecdotal reports that speculative demands were becoming apparent in the markets for single-family homes and condominiums.

What does this mean for the Indian stock markets?

While some market participants believe that a faster US economic growth augurs well for equity markets in general next year, investors also have to bear in mind that there could be re-allocation of money back to US equities next year. This is because US firms would benefit from this US economic recovery and profit growth could accelerate. The rationale that lack of adequate investment opportunity in the US has been resulting in FIIs pumping money into emerging markets may stand diluted to an extent in the future.

Secondly, given the fact that commodity prices are still ruling higher on a YoY basis, despite the recent weakness, combined with economic growth, interest rates in the US may rise. It has to be remembered that central banks across the world are concerned about inflation and price stability remains the key area of focus.

At the same time, concerns with regard to the large current account deficit in the US persists and how this issue will be tackled by the US government remains to be seen. Perhaps this is the key apprehension among investors, as far as the US economy is concerned.

What we suggest in this backdrop to retail investors in India is not to bank of just FII inflow to drive markets to new highs. In fact, the risk of FII inflows slowing down or flowing back exists. Given the sharp rise over the last two years, investors have to be cautious when it comes to investing in equities at the current levels. Return expectations needs to be toned down (around 15% to 18% return on equities over a period of three years is reasonable in nature). Also, investments need to be staggered over a period of time.