The Federal Reserve has made it clear in its recent meeting that not only will the federal funds rate begin moving higher soon but the surplus liquidity that was fuelling the asset price boom in global markets will also be withdrawn early. The ultra-low policy rates in the US will soon be history as the Fed Chairman Jerome Powell has indicated that an increase will be appropriate given the robust jobs market and sticky inflation, which is higher and longer-lasting than originally anticipated. While Powell said that the rate action will depend on incoming data, it is quite likely that the rate hike cycle could begin in the first quarter of this year. The rate hikes can also be aggressive in the initial months to tame inflation. The other major policy move that is going to have a widespread ramification on global financial markets is the Fed’s intention to stop net asset purchases in early March and to begin shrinking its balance sheet once policy rate hikes commence. While the timing and quantum of balance sheet tightening will be discussed and revealed over the coming months, this action will suck liquidity from the financial system.
Global financial markets are already beginning to heave. The MSCI World Equity Index is down 7 per cent since the beginning of this year with investors pulling money out of overheated stocks in all regions. Bond markets have also turned turbulent with 10-year US treasury security yield rising to 1.87 per cent, hardening 36 basis points over the past month. Sovereign bond yields in other countries are also rising as the world braces for the rate hike cycle to begin in the US. Institutional investors have begun reallocating funds out of risky assets such as emerging market equity, bonds and cryptocurrencies into safer havens of dollar denominated securities. This is causing currencies of emerging economies to weaken, further accelerating fund outflows.
Indian benchmark equity indices are down around 6 per cent from recent highs and 10-year government security yield has hardened over 40 basis points since December 2021. Policymakers will have to take the altered conditions in global financial markets into consideration going forward. . Foreign portfolio investors have turned net sellers this fiscal year, pulling out almost ₹45,000 crore while they had net purchased stocks worth ₹2,75,000 crore in FY21. This highlights the need to support domestic investor participation in equity markets to buttress prices in such times. Similarly, the Reserve Bank of India (RBI) needs to act fast to include government securities in the global bond indices so that the G-sec yields get some support at a time when FPIs pull money out of government bonds. Retail participation in government bond markets should also be promoted in order to create demand for these securities at a time when government borrowing is set to rise sharply. The forex reserves built over the last two years will be useful to support the currency if volatility increases. The RBI should keep up with its endeavour to add to its reserves in periods when foreign funds pour money into the country.