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Fed rate hike: Big deal?

Jul 1, 2005

"There is good growth and bad growth. The former is well supported by internal income generation and savings while the latter is driven by asset bubbles and debt," quips Stephen Roach, the noted economist. What he is indicating of is the current state of the US economy when the Federal Reserve's (very) low interest rate regime has fueled a bubble like situation in the US housing market, which has further acted as a fuel for rising inflation. However, the US central bank has 'long' realized this and has yet again announced a 25 basis points hike in the short-term interest rates, taking the same to 3.25%. However, what the fed has not done is to indicate when will these rate hikes terminate. In making this hike in the rates, the Fed has indicated that 'the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Although energy prices have risen further, the expansion remains firm and labor market conditions continue to improve gradually. Pressures on inflation have stayed elevated, but longer-term inflation expectations remain well contained.'

While not much should be read into this rate hike and the Fed statements following it, as this seems a repeat of what the Fed has stated in the recent past, Indian investors should note that the US Fed is gradually realising that the problem of high deficit is a consequence of its extensive liberal policies with respect to interest rates in the 2 years preceding June 2004 (when this round of rate hike began).

Greenspan seems to be finally owning up to the fact 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.

So, what should Indian investors do?
In light of the concerns that have been mentioned in the past with respect to a faster rise in US interest rates and Foreign Institutional Investors (FIIs) 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.

While there are no checks and balances as to what proportion of the current FII money is 'hot' in nature, what investors need to understand is the fact that the Indian banking system needs to reform faster to counter any 'shock' arising out of sudden money flows. One may believe that since we were able to insulate ourselves from the East Asian financial crisis of 1997, we will be able to do so yet again if an emergency of such kind reappears. But, it needs to be understood that the world has become even 'flatter' in these past decade, or more simply, the level of insulation of India from global events has reduced over these years. We now have more open capital markets than in 1997. We now receive much greater amount of foreign fund inflows than in 1997. And we are now more 'overly' bullish on the growth of the Indian economy than in 1997. All these excesses require that we become more cautious now.

Also, given the sharp rise in the value of equities over the last two years, investors have to be cautious when it comes to investing at the current levels. While there still are several stocks that will provide good value over the long-term, investors need to follow a bottom up approach to investing in these times. Also, apart from the fact that return expectations need to be toned down, investments should be made on a staggered basis. Greenspan will not matter then!

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