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Big Ben strikes 5! - Views on News from Equitymaster
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  • May 11, 2006

    Big Ben strikes 5!

    The US Federal Reserve is at it again! By raising its short-term rate yet again by 25 basis points to 5%, and then proclaiming that "some further policy firming may yet be needed to address inflation risks", the Fed has put to rest all optimism that the rate hiking cycle was nearing its end.

    The US central bank has, however, added a disclaimer to its proclamation regarding further rate hikes in the future. The Fed states that, "...the extent and timing of any such firming (in the future) will depend, importantly, on the evolution of the economic outlook as implied by incoming information."

    For the beginners, changes in this short-term rate (called as Fed funds' rate) is similar to the reverse repo rate as used by the Reserve Bank of India (RBI) to manage liquidity in the system. This rate is also a benchmark for other broader interest rates in the economy and impacts the cost of funds for borrowers-retail and corporate.

    As a matter of fact, the Fed's current rate now stands at its highest since March 2001, and is a culmination of the rate hiking campaign that began in June 2004 (the Fed has raised rates for 16 times in the past 22 months, each time by a quarter of percent). In the latest announcement, the Fed also goes on to state that economic growth in the US has been quite strong so far this year, and expects some moderation in the future growth due to 'a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.'

    Readers should note that this rate hiking campaign is not only towards paring the pressure arising from rising inflation levels in the US economy on the back of high crude and commodity prices. Rather, it is also a measure by which the US central bank might be trying to correct (or reduce) the impact of its huge current account imbalance, which has led to depreciation in the value of the US dollar in the past three years. Now, this depreciation has also added to the overall inflationary pressure in the US economy (as imports have become expensive).

    Considering this factor, we believe that there is no reason for the Fed to stop its rate hiking campaign in the near term. At around 4% inflation levels, the real interest rates in the US are still at the historically lower levels.

    What should Indian investors do?
    In light of the concerns that have been mentioned with respect to a faster rise in US interest rates and Foreign Institutional Investors (FIIs) reversing their direction towards the 'more attractive' and 'safer' US treasury bills, 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 in stock prices over the last two years, they have to be cautious when it comes to investing in equities at the current levels. Apart from the fact that return expectations have to be toned down, investments should be made on a staggered basis.



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