By: Punam Sharma
As the prospects for the first US Fed rate hike draw near, a justifiable question that investors would have is whether RBI can cut rates further when the Fed is hiking rates. We think yes and we explain our rationale via the series of charts below.
The above chart tracks the last Fed rate hike cycle between 2004 and 2006. Indeed, the RBI was also hiking into the cycle. This phase coincided with a significant commodity upswing as the CRB commodity index chart below demonstrates. Therefore, and as will be shown below, RBI rate hikes were necessary to keep real policy rates static. As is also evident from the same chart, we are now clearly in a reasonably sized global commodity downswing that started since 2011 coinciding with the Chinese industrialization cycle turning (Chinese PPI has now been falling since 2011 and been in outright deflation since 2012 as shown in the same chart)
Next look at the chart below that tracks US real policy rate (Fed funds minus Core PCE) and India real policy rate (RBI repo minus CPI industrial workers). CPI IW has long period history and tracks composite CPI closely.
Average real Fed funds rate between Jan 2003 – Dec 2004 was -0. 5%. Between Jan 2006 – Dec 2007 it averaged 2.8%. That is a massive swing and much more than anything potentially feasible in the current cycle (most predictions are for real Fed Funds rate to peak at 0% from approximately -1% now, as nominal rates will be hiked to 2% even as inflation rises to 2%). RBI’s real policy rate averaged 1.1% between Jan 2003 – Dec 2004 and 1% between Jan 2006 – Dec 2007. So there was little change in our real rates over this massive Fed rate hike cycle. One large reason we could manage such a large narrowing of real rate differential (in fact the real rate differential turned negative between 2006 – 07) is explained below:
Our basic balance (CAD plus FDI) was close to zero through 2008 which meant that our reliance on the volatile component of global capital flows was minimal. The same is borne out by tracking CAD which was at its worst around 1% of GDP during this period. Contrast this to 2010 – 2013 period where narrowing of real interest rate differentials also coincided with worsening CAD and basic balance. Little wonder then that we eventually had a funding crisis on our hands in 2013 inviting emergency measures. However, now the CAD and basic balance metric is back to resembling the 2005 – 2008 period which is consistent with a much narrower real interest rate differential without inviting any sort of a funding crisis.
So in summary:
1. The last Fed hike cycle was alongside a global commodity lift off and also ran coincident with RBI rate hikes. The situation today is of the global commodity cycle having turned sustainably for the past few years and lately showing further signs of a break down.
2. In terms of real rate differentials, Fed real rates rose on an average from -0.5% to 2.8% in the last hiking phase, even as our average policy real rates remained static through that phase at around 1%.
3. A significant reason why this could happen is that our sustainable external account (measured either in CAD or basic balance terms) was very comfortable. We are back to that phase over the past 1 year.
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