The end of the easy money era will impact your investments

Outside the Eco-Chamber

What if I were to say that the home prices in the United States impact the value of your investments in India. You will probably turn around and tell me to go take a walk.

But the fact of the matter is, there is actually a link between the two, and we have reached a stage where the link perhaps matters more than it ever did. But before we get into understanding this, let’s see how we got here in the first place.

In late 2019 and early 2020, rich-world central banks, led by the Federal Reserve of the United States (or the Fed), the American central bank, started to print a lot of money, first to take care of the economic slowdown and then the economic contraction because of the spread of the Covid pandemic.

The idea was to drive down interest rates. At lower interest rates, people were expected to borrow and spend money. Interest rates on 30-year tenure home loans in the US fell to as low as 2.65% in early January 2021, the lowest they had been since 1971, the year from which this data is available.

Naturally, with interest rates at such low levels, more people started borrowing and buying homes than was the case in the past. While the demand for homes went up quickly, their supply couldn’t go up as quickly to meet this extra demand. Hence, home prices went up, at a very past pace.

In April 2022, home prices in the US, as per the S&P Case-Shiller 20-City Composite Home Price Index, had gone up by 21.2% in comparison to April 2021. Home prices have been rising at more than 17% from May 2021 onwards. This kind of price rise wasn’t seen even during the real estate bubble of the 2000s.

One straight impact of this was rising home rents. As per Realtor.com, the median rent in the US in May 2022 was 23.2% higher than in May 2020 and 15.5% higher than in May 2021. This rise in home rents feeds into retail inflation. As The Economist puts it, in May 2022, the “rising housing costs already accounted for 40% of the monthly increase in the consumer-price index (which measures retail inflation).”

In May, the retail inflation in the US stood at 8.6%, the highest since December 1981, when it was at 8.9%. People are now building in this high inflation into their monetary calculations, in the home-rents they demand, and in the salaries and wages they ask for.

In the same month, the median one-year ahead expected inflation rate in the US was 6.6%, the highest that it has been in a while. As any economist would know, once inflation expectations set in the minds of people, it becomes very difficult for central banks to control inflation. So, in this scenario, it has become very important for the US Fed to control the fast pace at which housing prices have been going up, given that it can’t do much about the high energy prices, due to the war in Ukraine.

The Fed has decided to gradually withdraw some of the money that it had printed and pumped into the financial system. It expects to gradually suck out close to a trillion dollars, bringing an era of easy money to an end. This is already pushing up home loan and other long-term interest rates in the US. As of June 30, the median interest rate on a 30-year fixed interest rate home loan had risen to 5.7%, from a low of 2.65% in early January 2021.

As the Fed keeps sucking out money, the interest rate on home loans will keep going up, and this will hopefully drive down the demand for fresh homes and the rate of price rise. As home price inflation cools, rental inflation will also cool down and, in turn, bring down retail inflation. That’s the theory.

Other than taking out the money it had printed, the Fed also plans to raise its key short-term interest rate, the federal funds rate. This is expected to drive up short-term interest rates in the US.

The end of the era of easy money and rising interest rates in the US will have an impact on investments in India. In fact, this is already happening. The foreign institutional investors (FIIs) have already sold Indian stocks worth Rs 2.56 lakh crore (or trillion) between October 2021 and July 1. This has led to a fall in the value of investments in stocks, equity mutual funds and unit-linked insurance plans.

Further, as FIIs sell out of India, they convert their rupees into dollars, leading to a surge in demand for the dollar and a drop in the value of the rupee. One dollar is currently worth around Rs 79. It was worth around Rs 74.5 at the beginning of 2022. This makes life expensive for those looking to study abroad or go on a foreign holiday.

As the Fed raises interest rates, the Reserve Bank of India will have to do the same. This will push up interest rates on loans as well as on deposits in India. Hence, people with loans are likely to end up paying higher EMIs, whereas people with deposits are likely to earn a higher interest than was the case in the past. Again, this is already happening.

Of course, a big impact of the rise in interest rates in the US has been on crypto prices, which have crashed by close to 80% from their all-time high levels, leaving many Zoomers poorer.

All in all, as the old cliché goes, when America sneezes, the whole world catches cold.