The New Fed Rate Cut Certain To Impact Global Markets

Because of strong macroeconomic fundamentals and India being the fastest growing economy and the attractiveness of its economy, the RBI has been successful in creating buffer in terms of forex reserves

As expected, the Fed Reserve on December 18 announced a cut of 25 basis points in their policy interest rates, while simultaneously lowering the target range for the federal funds rate to 4.25 per cent from 4.5 per cent. This translates to an overall reduction of interest rates by 100 basis points from its peak after Fed started to cut the policy rates. In effect the policy stance is now significantly less restrictive.

Federal Reserve Chair Jerome Powell clarified "we can therefore be more cautious as we consider further adjustments to our policy rate. We see the risks to achieving our employment and inflation goals as being roughly in balance, and we are attentive to the risks on both sides of our mandate."

The cautious approach is distinct with his further take as regards additional cuts “we will be looking forward to further progress on inflation.” Fed target for inflation is at two per cent as against November’s 2.8 per cent, which had touched a high of 5.6 per cent.

“And as long as the economy and the labour market are solid, we can be cautious and consider further cuts. The December SEP shows a median forecast of two cuts next year compared to four in September."

Of course, the perspective will change significantly after Donald Trump assumes office on January 20.

Fed is still not sure of full control on inflation as it is likely to be between 2.5 and three, which is way below where it was. However, Fed hopes to see progress on inflation towards the durable target of two per cent.

Hence, one could see a hawkish approach than what the market expected and it has its impact on market. US stock indices dropped by varying degrees of three per cent, Treasury yields and dollar rose to 4.5 per cent and 108, respectively, while gold fell two per cent. This had an impact on emerging markets as well as a strengthened dollar will result in a fall of other currencies, which was quite steep in Asian currencies.

Indian equity indices also fell and the Sensex and Nifty 50 were down by over four per cent each, while Nifty Bank tumbled by over five per cent last week. The Indian markets were already weakened due to less than expected corporate earnings. Things are in for dramatic changes given that Trump has been openly stating that India has been charging high tariffs. This can impact exports to USA, which is a major partner for India. More than anything, the outcome of the Fed Reserve meeting added to the uncertainties with foreign portfolio investors moving to safer zones as the US dollar was strengthening at steady pace.

The dollar index surged to a high of 108.54 last week. The higher US Treasury yields and push to greenback up resulted in the Indian rupee falling to 85.07 on December 19, from the 85 mark last week. The Indian currency recovered slightly and closed at 85.02 at the weekend.

Even though Indian rupee has shown a depreciation trend, it is relatively better as its depreciation since November 4 is at a steady 1.11 per cent. With focus and all eyes on the policy decisions of the Trump 2.0 administration, a report by SBI research states that the rupee may depreciate eight to 10 per cent against the US Dollar.

Indian forex reserves stood at $652.869 billion as on December 13, which is negative of 1988 million over the earlier week. The Reserve Bank of India (RBI) has built sufficient forex reserves over a period of time and these will be the strength when there is volatility. The June report of RBI shows India's forex reserves cover at 11.2 months of imports. There may be slight variations as of date. However, because of strong macroeconomic fundamentals and India being the fastest growing economy and the attractiveness of its economy, the RBI has been successful in creating buffer in terms of forex reserves.

As of November, total trade (merchandise plus services) stood at $67.79 billion against the 2023 level of $61.85 billion whereas imports have been substantially higher this November at $87.63 billion as against the November 2023 level of $68.74 billion, which has led to trade balance deficit rising from $6.89 billion to $19.84 billion. The sources of foreign exchange inflow from net FDI, net foreign portfolio investors, NRI and FCNR funds, exports, less imports, remittances like dividend and royalty add to our forex reserves More less dependence on unnecessary imports also reduce our burden on forex outflow on account of imports. Whenever rupee has an impact on account of external factors and shows depreciation, it adversely hits our imports, particularly of essential items like oil, raw materials and gold, among others. However, the country has been managing its imports of oil by sourcing from different quarters thereby getting the benefits of price coupled with efforts to boost production of electronics, automobiles and solar, which are enhancing our exports.

The RBI has not resorted to rate cut yet and what will be the extent of rate cut in 2025 will be pertinent.

Apparently, the central bank will keep track of the incoming data on food prices, growth and inflation dynamics before taking a call on future rate action.

(The author is former Chairman & Managing Director of Indian Overseas Bank)