Higher interest rates will affect global fund flows

Financial markets operate on the assumption that currency prices may remain high in the near future. Last week the 10-year US government bond yield crossed the psychologically important 5 percent level. This happened after 16 years. Due to this, bond and equity markets around the world saw a decline. The current rise in bond yields is attributed to the perception that policy interest rates in the US will remain at high levels for an extended period of time. US Federal Reserve Chairman Jerome Powell and other policymakers have recently publicly asserted that interest rates will be kept high to keep inflation around two percent.

However, financial markets expect the Federal Reserve to keep policy rates steady at its meeting next week. However, the market is eyeing the possibility of at least one more rate hike in the current cycle. Looking beyond the Federal Reserve's immediate policy imperatives, the US economy is undergoing structural changes that could keep currency costs high for an extended period of time.

For example, the budget deficit in the United States has increased compared to recent decades. Due to this, the demand for financial savings has increased. This can also sustainably increase the value of the currency. It is also to be noted that the demand for American bonds etc. has decreased due to many reasons in countries like China.

These countries have been pouring their excess savings into US Treasuries for years. This comes at a time when the Fed is shrinking the size of its balance sheet. All these things together will put pressure on yields. With greater demand for savings by the government, the demand for and supply of total savings is also undergoing significant changes.

To assess why interest rates have fallen in recent decades and how they will move into the future, economists look at half a century of data and estimate the price of 10-year US government bonds after adjusting for inflation. The natural rate of interest declined from 5 percent in the 1980s to 2 percent in the last decade.

The natural rate usually means the interest rate that balances savings and investment. The natural rate will increase by one percentage point from 1.7 percent in 2010 to 2.7 percent in the 2030s. It means that the yield on 10-year government bonds will be between 4.5 to 5 percent and the risk will be upside.

If all goes as predicted, the coming years will be different from the previous years. Systemically high interest rates in the US and perhaps other developed countries will affect global fund flows.

The increased cost of capital will not only affect global growth prospects but also increase credit and liquidity risks for many developing countries. It is important for a country like India to address the threats to macroeconomic stability and increase domestic savings.