In one of the most anticipated events in the global economic calendar the US Federal Reserve decided to hold rates for now, thereby, prolonging global uncertainty. In maintaining the status quo the Fed appears to have bowed to strong headwinds originating from a slowing Chinese economy. It is also recognition that despite its resilience, the US economy is not strong enough to do away with stimulus.

The mood before

By the middle of last week, the financial markets around the world were on an edge in anticipation of a rate action by the US Federal Reserve, which was scheduled to be announced late on Thursday September 17 (Indian time). With Indian markets having a holiday on Thursday, the actual impact of the US action would in any case be expected only on Friday. The US Federal Reserve’s two-day meeting to decide whether to hike interest rates for the first time since 2006 began on Wednesday. A large part of the mystique surrounding the US Fed action has been the absence of cues from the higher echelons of the Federal Reserve.

The rate increase, highly probable though it appeared, was by no means a given. According to influential surveys, there were as many experts ruling out a rate increase as there were expecting one. The IMF and the World Bank had come out against a rate hike on the ground that it would roil the markets. This was the stand taken by India and a few major emerging markets earlier but closer to the date the consensus opinion had shifted in favour of getting through with it rather than living in an environment of uncertainty. The realisation that whatever action the US authorities will take will be centred on the US economy — its growth rate, inflation and employment figures — has helped in taking a more nuanced view of the Fed’s action. A balanced view was that the US Fed would raise the rate but the question remained as to when.

Past record of the US Fed gave no firm indication either. Its main interest rate has been practically zero since the dark days of the financial crisis. The target range is zero to 0.25 per cent, for the overnight interest rate that banks charge for lending to one another. The rates have remained unchanged since December 2006, a few weeks after the collapse of the investment bank, Lehman Brothers. It is certainly an unprecedented situation, a section of US policymakers wanted to begin unwinding just as soon as they were satisfied that the economy is strong enough. It may be noted that the other component of the ultra soft monetary policy — quantitative easing (QE) -- is being unwound in stages beginning end-2013. QE has involved massive purchase of bonds by the Fed with newly created money to keep interest rates low. The question, therefore, on the eve of the Fed meeting last week was: is the US economy strong enough to begin the return to normality?

Supporters of an end to ultra-soft monetary policies would argue that the recovery from the recession that followed the financial crisis began in June 2009. Since then the economy has grown at an annual average rate of 2.2 per cent, which though not particularly impressive, has been strong enough to leave the economy 9 per cent larger than its pre-recession peak. The next important indicator is the job market .On the face of it, it looks healthy. Unemployment is down to 5.1 per cent. Average corporate earnings have been on the rise. A strong employment market suggests a case for raising rates, given the higher wages that companies may have to pay. That could mean more inflation.

The Fed’s interpretation of its mandate is to promote stable prices at an inflation target of two per cent. Based on current data, consumer prices did not suggest a strong need to raise interest rates quickly,

Another important development that weighed against raising rates is the unexpected slowing down of the Chinese economy. Global financial markets have been extremely volatile,

Holding fire for now

In the event, the Fed’s decision to hold interest rates at between 0 to 0.25 per cent predictably went off well with emerging markets. Led by bank stocks, the Sensex and the Nifty zoomed early morning on Friday.

There are at least two reasons why the Fed held fire, waiting for the next policy meets in October and December. The domestic economy has proved to be resilient but the US policymakers were not prepared to dampen the recovery through a rate increase. The Fed has noted signs of fragility. The second related reason is that the Fed is concerned with the slowdown in China and the uncertainty over the policy measures adopted by its authorities.

For India the upshot of all this is that the long period of uncertainty over the US monetary policy will continue.

crl.thehindu@gmail.com

(This article first appeared in The Hindu dated September 21, 2015)

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