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Fed rate hike: What is the impact?

May 4, 2005

The UD Federal Reserve has increased interest rates for yet another time by 25 basis points taking the benchmark rate to 3%. The stance of the monetary policy has also been maintained with specific mention about and inflation expectations, which according to the Fed, remains contained. While much has been discussed and debated about the US current account deficit and what can the Fed do to contain the same, here, we take a look at some of the macro economic indicators to put things in perspective. The two graphs below highlight the GDP growth rate trend of the US economy on a yearly and on a quarterly basis. If one were to consider the growth rate of the economy at 4.4% YoY in the calendar year 2004, it is among the highest since 1988 (4.5% earlier in 1999), a clear indicator that the US economy has come out of the trough post September 11 on the back of consumer spending and productivity improvement.

Another key indicator of the economic recovery, which every economist in the US was closely monitoring before two years, was the unemployment rate. After huge layoffs post the September 11 incidence, there has been stable recovery in unemployment rate. This is indicated in the graph. In the Fed statement released yesterday, it has mentioned, "labor market conditions, however, apparently continue to improve gradually". Considering the productivity improvement that the US economy has witnessed, economists believe that that corporates in the US will have to expand capacities for which additional investments may be required. This additional investment, in turn, is expected to improve the unemployment rate further in the future.

Coming to the interest rates in the US, the Fed's policy to adopt a 'measured pace' has had an impact on the US economy in terms of growth. This is evident from the GDP growth rate on a quarterly basis, which seems to have softened in the last three quarters. Typically, any increase in interest rates tends to have a lag effect on economic demand and growth. Though the Fed has been increasing interest rates for more than a year, the effect is to an extent visible in the recent GDP growth numbers. Prior to the yesterday's meeting, stock markets and economists across the world were concerned about the Fed raising interest rates at a faster clip. May be, the recent slowdown in GDP growth has given more room for the Fed to keep the 'measured pace' stance. In fact, Stephen Roach, a noted economist, has mentioned that "With America's cyclical impetus now fading, post-bubble fault lines could deepen -- making it all but impossible for the Federal Reserve to normalize real interest rates. This week could mark the Fed's last rate hike of this cycle"

With respect to the implications of this move on the Indian stock markets, as we have maintained before, equity money flows into emerging markets like India could be impacted in the medium term. While we continue to be strong believers of the 'India story' from a long-term perspective, the recent slow down in FII inflows does point to the fact that it may not be a easy ride for the Indian stock market this fiscal. Therefore, investing in stock markets on the belief that Foreign Institutional Investors (FIIs) will continue to pump in money into India is fraught with risk. To that extent, one has to be cautious.


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