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Wednesday, March 25, 2015

The likely effects of a US interest rate hike on global markets – a guest post

The US economy has been on a revival path for quite some time. The Quantitative Easing programme to stimulate a sluggish economy was gradually tapered off last year. With inflation showing signs of inching up, the stage is getting set for a possible interest rate hike by the US Fed.

Why should that be of any interest to Indian investors? Because the global economy has become a lot more interconnected. A rate hike in the US, coupled with a strong Dollar, may be a signal for FIIs to withdraw money from emerging markets (including India).

In this month’s guest post, Nishit discusses the current economic scenario in the US, and the possible effects of an interest rate hike on world markets.

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World markets were on tenterhooks – awaiting the US Fed announcement of a possible interest rate hike. Why are markets so obsessed with the US Fed decision to hike rates and how does it affect world markets?

The US Fed’s answer to the 2008 economic crisis was throwing cash to plug the gaps. They printed money and called it ‘Quantitative Easing’. Large amounts of money were made available at very low interest rates. This money found its way into many emerging markets, like India, and boosted their stock markets.

The idea was simple: borrow in the US at almost zero interest rates, invest in stock markets worldwide and mint profits. Since the rate of interest was almost zero, the currency risks were taken care of.

Quantitative Easing seemed to have worked and the US economy in the past 2 years has shown signs of recovery and growth. It is no more in recession, jobs are being added and the crutches of stimulus are no longer needed.

The US Fed had to account for this surplus printing of money and as a first step they tapered off the Quantitative Easing programme.

The next step is to hike up the interest rates as easy money can lead to inflation and creation of bubbles. Low interest rates helped to provide stimulus to the economy. Now, when the economy is up and running, the rates have to go up gradually for two simple reasons.

First is to prevent the formation of economic bubbles, and second is to provide room and buffer for providing another stimulus if the economy goes into recession again. After all, one can cut rates only up to zero.

In an isolated scenario this is fine. But in the case of the US - since it is the global leader - this extra money has been invested into various asset classes across the world. If the Fed starts hiking rates, then this money may be withdrawn from the various asset classes and will flow back to the US. The US Dollar has already started strengthening in anticipation of this.

Such a situation can lead to recession in other parts of the globe. Since the global economy is interconnected and the US companies also get a major part of their income from places other than the US, the Fed needs to tread cautiously.

To counteract the likely US withdrawal of stimulus, we have the Japanese stimulus and now the European Central Bank stimulus.

This is one of the anticipated reasons our markets are falling. One needs to keep an eye on how this plays out.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan. You can reach him at nish.stockid@gmail.com)

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