What Next On Interest Rates

The rise in yields at the long end indicates that the market expects higher interest rates. After continuously declining over a long period, interest rates had reached a trough. No one expected them to fall anymore. Yet, they were not rising. The market has almost been waiting for a trigger for the rates to start going up. Have today’s inflation numbers provided that trigger?

Why should rates be expected to go up?

First, there have been a number of signals that the US Federal Reserve Bank would raise interest rates. GDP growth in the US economy is high and inflation is rising. The question is no longer whether the Fed would raise rates. The question is when.

It has been suggested that the Fed may be averse to raising rates before the Presidential election. However, as the economy heats up, Greenspan could choose to start inching up rates in the next few weeks. The increase in US interest rates is expected to lead to a withdrawal of funds from all over the world into the US.

Emerging market economies, including India, have seen some indications of this already in May. This is expected to lead to a decline in liquidity and therefore, an upward pressure on rates everywhere.

Second, domestic factors including recent data on inflation, GDP and fiscal deficits have raised expectations of higher rates. The inflation rate has been slowly rising. The increase in inflation has led to higher inflationary expectations. If it is reasonable to expect about a 2 per cent real rate of interest in the long run, an increase in the inflation rate suggests that the nominal interest rates should be higher. With the upswing in GDP growth, it is expected that demand for credit from the private sector would increase. This along with higher borrowing by the government could put further upward pressure on interest rates.

Ila Patnaik