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The Central Bank capers... - Views on News from Equitymaster
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  • Sep 1, 2006

    The Central Bank capers...

    Will it or will it not?...that is the question! With major economies across the world keeping a close watch on inflation and interest rates, the central bank's ritual of taking a quarterly review of the economy has become a much-awaited 'event' of sorts! Infact, whether or not the central bank (here it means the Fed as well as the respective central banks of different countries) will resort to another 'quarter-point' rate hiking campaign - is a debate, which has become the flavour of equity markets across the globe.

    Fed and RBI: Brothers in arms?
    With the Fed having raised the interest rates by quarter percentage point each time for 17 instances - to 'tighten' the economy and control the burgeoning fiscal deficit baggage of the US, the Reserve Bank of India found it hard to resist from doing so. With this, the Reserve Bank of India (RBI) raised the benchmark repo and reverse repo rates twice this year and aligned itself with its peers across the globe. However, as soon as the Fed chose to adopt a 'wait and watch' approach before embarking on the 18th rate hike in the last FOMC (Federal Open Market Committee) meeting, the RBI too rolled back its sleeves. In their recent releases (the Fed minutes and the RBI annual report), both the central banks have tried to sweeten the pill, while justifying the status quo on interest rates and at the same time highlighted their concerns. In a way, they have done their best to keep the investors guessing!

    What the Fed has to say...
    The Fed noted that the global demand remained strong, potentially adding to worldwide pressures on resources. Increased geopolitical risks, particularly related to developments in the Middle East, continued to put pressure on energy prices, and the prices of many other commodities also had firmed up over the inter-meeting period. Also, the fact that central banks globally had been raising interest rates was viewed as a factor that should help to restrain global inflation pressures. But it was also noted that the recent decline in the foreign exchange value of the dollar could lead to a weakening of import competition in the form of increases in the prices of tradable goods in the United States. The bank confirmed that the slowing down of GDP growth in the second quarter was largely in line with expectations, reflecting the continued cooling of the housing market, the restraining influence on demand of higher energy prices, and the lagged effects of past increases in interest rates. In the same breath, the Fed re-iterated that the inflation risks remained dominant and that consequently keeping policy unchanged at the previous Fed meeting did not necessarily mark the 'end of the tightening cycle'.

    What the RBI has to say...
    The Reserve Bank report concurred that the balance of payments position remained comfortable during FY06 despite pressures imposed by higher international crude oil prices and outgo on account of redemption of IMDs. The current account deficit remained at a modest 1.3% of GDP benefiting from the sustained growth in exports of software and other business services. Here again, the central bank highlighted the risks emanating from the global economy, including volatility in international crude oil prices, a disorderly unwinding of the macroeconomic imbalances of the major economies, firming up of overall inflationary pressures and above all - a hardening of international interest rates along with the withdrawal of monetary accommodation. Domestic conditions relating to the progress of the monsoon, infrastructure bottlenecks and emerging apprehensions regarding the fiscal outlook continue to feature amongst the RBI's list of concerns.

    What should be construed?
    While it is rather evident that both the central banks continue to signal impending rate hikes, the question is not 'whether' but 'when'? Although the industry-specific factors (be it demand for credit, commodities or consumer goods) are yet to exhibit signs of slowdown, the larger macro economic are certain to have a lagged impact of the same. Already, the ECB has mentioned that there may be a need to increase interest rates in the near term because the actual inflation is likely to be higher than the initial estimates. It would thus be proactive on the part of investors to factor in such possibilities in their long-term assumptions, rather than be part of the speculation game. This is so that you are not caught unawares when the tide turns!



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