Finally the Fed decided it could take the US economy off life support and try to move towards more ‘normal conditions’. The federal funds rate (the rate banks charge each other for overnight loans) is now targeted to shift to 0.25-0.50 per cent range, from the earlier 0-0.25 per cent .

The last time the Fed lifted rates from an extended period near zero was 1947. So, how is this new target range to be achieved, what is the prognosis for the future evolution of US rates and its implications for other markets? In the past, the Fed has been able to shift interest rates by buying and selling US government debt. By selling securities to banks the Fed would make money more expensive. This would raise the cost of overnight loans which, in turn, would be transmitted to the wider economy.

Overnight rate

But this mechanism may not work anymore, given the huge sums (about $4 trillion) which the Fed has pumped into the economy since year 2008 as part of the quantitative easing program — US treasuries and other securities were bought to stimulate the economy. It would be difficult to increase rates in the face of this massive pool of liquidity, hence newer tools.

The ‘overnight reverse repo’ agreement (simply the overnight rate at which the Fed will borrow money using eligible securities as collateral) is now raised to 0.25 per cent from 0.05 per cent. This should effectively act as the floor of the fed funds target range. On the upper end, it uses the interest rate on excess reserves (IOER) rate; this is the rate of interest the Fed pays banks which park with it excess reserves — the logic being banks would be unwilling to lend at lower than the IOER — given it would be the least risky proposition to simply lend to the government-backed Fed.

Rate outlook

The Fed was not more or less dovish as compared to market expectations. Additionally, the communication content of Fed Chair Janet Yellen was on expected lines — suggesting a gradual pace of normalising rates. While the Fed managed to engineer a very smooth lift-off, the path of future rate increases is showing divergences between Fed median projections (1.375 per cent by end 2016) and market implied rate, which is currently closer to 0.85 per cent for December 16.

We expect three more rate hikes in 2016 with the next one due next March and the 10-year Treasury yield to move to 2.75 per cent by end 2016. We expect rate increases to accelerate in 2017 as inflation approaches 2.0 per cent and international headwinds dissipate. In our view, the key risks to this outlook are a potential hard landing in China, stronger dollar and perhaps tighter financial conditions. As per the Fed, for rate hikes to stall, inflation would have to be significantly lower relative to its expectations.

So what will be the immediate impact? For starters, the US government will pay a lot more in terms of interest over the next 10 years as rates rise slowly. Some estimates suggest this could be more than $2.5 trillion. Returns on funds parked in banks will likely improve, albeit slowly, and incremental benefits to savers will probably be slow in coming. For commercial banks, the impact could vary — depending on their business mix. Under the ultra low rate regime, bank lending margins had sharply reduced; now there may be some relief. Commodity prices are unlikely to be impacted much in the short term.

We believe ongoing macro headwinds will remain a significant hurdle that will continue to restrain risk taking and capital inflow into emerging markets, as seen in the chart.

The writer is Head Global Markets, India, at Société Générale

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