Impacts of Federal Reserve Rate Hikes on Global Markets and RBI Policy

The increase in interest rates by the U.S. Federal Reserve (Fed) has been a topic of discussion in the global financial markets. Markets already anticipated an additional six rate hikes this year, aligning with the Fed's actions. However, given the high level of inflation in the U.S., the Fed is considered to be behind the curve, with real interest rates reaching unprecedentedly low levels.

Initial Rate Increases and Market Reactions

Initial rate increases typically do not significantly impact the markets as the change in the discount rate is minor. Only when the rate hikes are substantial do markets react negatively, as the market adjusts to the increased discount rate and decreases multiples. In the case of the Fed's current rate hike, which was well-telegraphed, the market was already prepared for it.

Impact on High-Growth Companies

High-growth companies, which have benefited from near-zero interest rates, have experienced notable corrections. Many have seen their market values drop by 50% to 90%. This underscores the significant impact high interest rates can have on investment valuations, especially in growth-oriented sectors.

RBI's Monetary Policy in the Face of Inflation

Meanwhile, the Reserve Bank of India (RBI) is grappling with inflationary pressures while attempting to maintain loose monetary policy. Despite inflation levels around 6%, the lack of the reserve currency benefit means that India cannot have real negative interest rates. Moreover, government inflation is reported at around 6%, while household survey data indicates a much higher rate of 11%.

Policy Divergence and Expected Fallout

The widening policy divergence between the Fed and the RBI is anticipated to lead to significant consequences. Specifically, the rupee is expected to depreciate rapidly, and global price hikes, including vegetable oil, crude oil, and food prices, are also expected to soar. This depreciation and price increases will contribute to a sharp rise in India's inflation rate.

Death Spiral and the Need for Action

With the combination of a depreciating currency and skyrocketing inflation, a dangerous cycle could emerge where the inflation rate continues to rise uncontrollably. This situation can only be contained with aggressive interest rate hikes, indicating the urgency for the RBI to act now.

Conclusion and the Risk of Stagflation

The RBI must take swift action to normalize interest rates. Waiting till later in 2022 could lead India into a perilous economic situation, with potential political upheaval and slowed growth. The central bank could then face the double challenge of combating hyperinflation and dealing with economic stagnation, which would be a nightmare scenario for any central banker.