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What is Fed hinting at?

Feb 17, 2005

In his testimony to the US Senate Banking Committee, the Chairman of the Federal Reserve, Alan Greenspan hinted at a further hike in interest rates, citing reasons like improvement in the US economic fundamentals and low savings of consumers. He indicated that the rise in rates would continue to be 'gradual' (read measured) and that it was an 'imperative to restore fiscal discipline in the United States to help narrow the huge trade deficit.' While not much should be read into this testimony as this seems a repeat of what the Fed has stated in the recent past and has failed to deliver, Indian investors should note that this is one of first times that Greenspan has seemed to confess that the problem of high deficit is a consequence of the extensive liberal policies of the Fed with respect to interest rates in the past 2 years.

In the recently held 'Advancing Enterprise 2005 Conference' in London, Greenspan had owned up that the fall in US interest rates since the early 1990s has supported both home price increases (the asset bubble as it is termed) and, in recent years, an unprecedented rate of existing 'home turnover'. This combination has then led to a significant rise in debt on account of home mortgages. What Greenspan meant from the latter (home turnover) was that the sharp rise in home prices has created capital gains for owners, which become realised with the subsequent sale of a home. A large proportion of this money is then used to purchase another home and the remaining part is used for 'consumption' purposes. This has been the chief perpetrator of the rising US personal dissavings. And so the Fed decision to now raise interest rates at a faster clip to reign in the bubble.

A case in point was the minutes of the meeting of Federal Reserve (held on December 12, 2004) that were released last month. Some accompanying facts of the minutes led to investors across the world panicking in belief that the faster rise in the US interest rates will lead to the 'hot' Foreign Institutional Investors (FIIs) money reversing its flow, back towards the relatively safer US treasury bills and bonds.

The minutes of the aforesaid meeting indicated that the US economy expanded at a moderate pace in the second half of 2004, with both consumer and investment spending remaining robust. However, while core inflation remained subdued, prices rose slightly higher than in 2003. This was much owing to the indirect effects of higher energy prices. It was also indicated that the recent depreciation of the US dollar against key currencies was also putting pressure on inflation, thus increasing risks of a faster rise in prices going forward.

These key details of the Fed meeting led market participants to believe that the US central bank might raise interest rates faster than in the past, thus increasing risks of re-allocation of FII money back to US equities in 2005. Apart from that, the fact that economic policies across the globe are now more integrated than ever before, investors seemed to have believed that in light of the US Fed raising interest rates at a faster pace, central banks across the world

So, what should Indian investors do?

In light of the concerns that have been mentioned above with respect to a faster rise in US interest rates and FII flows reversing their direction, thus leaving local investors in the lurch, we suggest that investors should not bank on just FII inflows to drive markets to new highs. Also, 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. Apart from the facts that return expectations have to be toned down, investments should be made on a staggered basis.

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