How the American real estate bubble impacts you and your investments

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 ask me to go take a walk.

But the fact of the matter is that there is actually a link between the two and we have reached a stage where the link perhaps matters more than it ever did. Nonetheless, before we get into understanding this, it’s important to know 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, 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 thirty year home loans in the United States 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, went up by 21.2% in comparison to April 2021. Home prices have been rising at more than 17% year on year from May 2021 onwards. This kind of price rise wasn’t even seen during the real estate bubble of the 2000s.

One straight impact of this has been rising home rents. As per Realtor.com, the median rent in the United States 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 2022, the retail inflation in the United States 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 May 2022, the median one-year ahead expected inflation rate in the United States was 6.6%, the highest that it has been in a while. As any economist would put it, 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 Federal Reserve 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 Federal Reserve has decided to gradually withdraw some of the money that it had printed and pumped into the financial system. Between June 2021 and May 2022, it expects to 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 United States. 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 of homes. As home price inflation cools down, 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 Federal Reserve also plans to raise its key short interest rate, the federal funds rate. This is expected to drive up short term interest rates in the United States.

The end of the era of easy money and rising interest rates in the United States 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 trillion between October 2021 and July 1, 2022. This has led to the value of investments in stocks, equity mutual funds and unit linked insurance plans, falling.

Further, as FIIs sell out of India, they convert their rupees into dollars, leading to a surge in the demand for the dollar and 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 to go for a foreign holiday.

As the Federal Reserve 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 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 United States 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.

This piece originally appeared in the Deccan Herald on July 3, 2022, with a different headline.

Janet Yellen’s tourist dollars are driving up the Sensex

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Central bankers drive stock markets. At least, that is the way things have been since the current financial crisis started in September 2008, when Lehman Brothers, the fourth largest investment bank on Wall Street went bust.

On March 30, 2016, the BSE Sensex rallied by 438 points or 1.8% to close at 25,338.6 points. What or rather “who” was responsible for this rally? Janet Yellen, the chairperson of the Federal Reserve of the United States, the American central bank.

Yellen gave a speech on March 29. In this speech she said: “I consider it appropriate for the committee to proceed cautiously in adjusting policy.” The committee Yellen was referring to is the Federal Open Market Committee or the FOMC.

The FOMC decides on the federal funds rate. The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.

In December 2015, the FOMC had raised the federal funds rate for the first time since 2006. The FOMC raised the federal funds rate by 25 basis points (one basis point is one hundredth of a percentage) to be in the range of 0.25-0.5%. Earlier, the federal funds rate had moved in the range of 0-0.25%, for close to a decade. FOMC is a committee within the Federal Reserve which runs the monetary policy of the United States.

The question that everybody in the global financial markets is asking is when will the FOMC raise the federal funds rate, again? It did not do so when it met on March 15-16, earlier this month. The next meeting of the FOMC is scheduled for April 26-27, next month.

By saying what Yellen did in her speech she has essentially ruled out any chances of the FOMC hiking the federal funds rate in April 2016. This is the closest a central bank head can come to saying that she will not raise interest rates any time soon.

This was cheered by the stock markets all over the world. Yellen basically announced that the era of “easy money” was likely to continue, at least for some time more.

This means that financial institutions can continue to borrow money in dollars at low interest rates and invest this money in stock markets and financial markets all around the world, in the hope of earning a higher return.

This means that the “tourist dollars” are likely to continue to be invested into the Indian stock market. Mohamed A El-Erian defines the term tourist dollar in his new book The Only Game in Town. As he writes: “During periods of large capital flows induced by a combination of sluggish advances economies, robust risk appetites, and highly stimulative central bank policies, emerging markets serve as destination for a huge pool of crossover funds, or what I refer to as tourist dollars.

As Erian further writes: “Rather than “pulled” by a relatively deep understanding of country fundamentals, this type of capital is typically “pushed” there by prospects of low returns in their more traditional habitats in the advanced world.”

The federal funds rate in the United States is in the range of 0.25-0.5%. In large parts of Europe as well as in Japan, interest rates are in negative territory. In this scenario, the returns available in these countries are very low. At the same time, it makes tremendous sense for financial institutions to borrow money at low interest rates from large parts of the developed world and invest it in stock markets, where they expect to make some money.

And India is one such market, where these “tourist dollars” are coming in and will continue to come in, if the central banks of the developed world continue running an easy money policy.

What got the stock market wallahs all over the world further excited was something else that Yellen said during the course of her speech. As she said: “Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation. In particular, we could use the approaches that we and other central banks successfully employed in the wake of the financial crisis to put additional downward pressure on long term interest rates and so support the economy.”

What does this mean? This basically means that, if required, the Federal Reserve will print money and pump it into the financial system to drive down long-term interest rates in the United States, so that people will borrow and spend more. This was the strategy that the Federal Reserve used when the financial crisis started in September 2008. This basically means that the era of easy money unleashed by the Federal Reserve is likely to continue in the days to come.

Now only if the Modi government could get its act right on the economic front., the tourist dollars would just flood in.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on March 30, 2016

Janet Yellen raises interest rates. What happens next?

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In the column dated December 16, 2015, I had said that the Federal Reserve of the United States would raise the federal funds rate, at the end of its meeting which was scheduled on December 15-16, 2015. That was the easy bit given that Janet Yellen, chairperson of the Federal Reserve of the United States, had more or less made this clear in a speech she made on December 3, 2015.

The Federal Open Market Committee(FOMC) of the Federal Reserve of the United States raised the federal funds rate by 25 basis points (one basis point is one hundredth of a percentage) to be in the range of 0.25-0.5%. Earlier, the federal funds rate moved in the range of 0-0.25%. FOMC is a committee within the Federal Reserve which runs the monetary policy of the United States

The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans. This is the first time that the FOMC has raised the federal funds rate since mid-2006.

I had also said that the Yellen led FOMC would make it very clear that the increase in the federal funds rate would happen at a very gradual pace. The statement released by the FOMC said that it expects the “economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”

As Yellen put it in central banking parlance in the press conference that followed the Federal Reserve meeting: “The monetary policy will continue to remain accomodative”. In fact, the members of the FOMC expect the federal funds rate to be at 1.4% in a year, 2.4% in two years and 3.3% in three years.

If the federal funds rate has to be at 1.4% one year down the line, then it means that the FOMC will have to raise the federal funds rate by around 25 basis points each (one basis point is one hundredth of a percentage) four times next year. This seems to be a little difficult given that the presidential elections are scheduled in the United States next year. Also, there are other problems that this could create.

The low interest rate policy was unleashed by the Federal Reserve in the aftermath of the financial crisis which started in September 2008, when Lehman Brothers, the fourth largest investment bank on Wall Street went bust. The hope was that both households and corporations would borrow and spend more and in the process, economic growth would return.

What has happened? The household debt to gross domestic product(GDP) ratio has been falling since the beginning of 2009 as can be seen from the accompanying chart.

 

The household debt to GDP ratio has fallen from around 98% of the GDP at the beginning of 2009, around the time the financial crisis had just started to around 79.8% of the GDP now. What this tells us is that the household debt as a proportion of the total economy has come down. This despite low interest rates being prevalent when at least theoretically people should have borrowed and spent more money.

Take a look at the following chart. It shows that the proportion of the disposable income that Americans are paying to service their debts has also improved. In end 2007, Americans were spending 13.1% of their disposable income to service debt. It has since fallen to 10.1%, though it has jumped a little in the recent past. But the broader trend is clearly down.

What these two graphs tell us clearly is that the household debt in the United States has come down in the aftermath of the financial crisis. So if households have not been borrowing who has? The answer is corporates.

As Albert Edwards of Societe Generale wrote in a research note in November: “The primary driver for the rapid rise in bank lending…has been borrowing by US corporates and we all know they have been using the Fed’s free money not to invest in capacity expanding expenditures, but rather to buy back mountains of their own shares…Corporate debt borrowing at an $674bn annual rate [is] closing in rapidly on the all-time borrowing splurge of 2007!

In another note released after the FOMC decision to raise the federal funds rate Edwards writes that “the real rate of corporate borrowing is even greater than was seen during the late 1990s tech bubble.”

American corporates have borrowed at rock bottom interest rates not to expand their capacities by building more factories among other things, but to buy back their shares. When a corporate buys back and extinguishes its own shares, fewer number of shares remain in the open market. This pushes up the earnings per share of the company. This in turn pushes up the share price. A higher earnings per share leads to a higher market price.

As a result of all this borrowing, the US corporate debt has reached 70% of the GDP, around the level it was at the time the financial crisis started. A Goldman Sachs research note points out that between 2007 and now, the total borrowing of the US corporates has doubled.

Nevertheless, all this money needs to be repaid. And this will become increasingly difficult with sales of US corporates falling. As Edwards writes in his latest research note: “It doesn’t help that both corporate profits and revenues are now falling…Nominal business sales have been contracting all year. Originally, it was put down to unseasonably cold weather – but the chilly data has just not gone away, as a combination of unit labour costs and weak pricing power have led to a typical late cycle decline in profit margins.”

If the Federal Reserve keeps increasing the federal funds rate, the interest rate that American corporates need to pay on their debt will keep going up as well.

The interest rate that the American corporates have been paying on their debt has fallen from 6% in 2009 to around 4% in 2015. A higher interest rate would mean a further fall in the profit made by American companies. Lower earnings would lead to lower stock prices and lower broader index levels.

And this is not something that the Federal Reserve would want. A falling stock market because of higher interest rates would jeopardise the American economic recovery.

As Yellen said in her speech earlier this month: “Household spending growth has been particularly solid in 2015, with purchases of new motor vehicles especially strong….Increases in home values and stock market prices in recent years, along with reductions in debt, have pushed up the net worth of households, which also supports consumer spending. Finally, interest rates for borrowers remain low, due in part to the FOMC’s accommodative monetary policy, and these low rates appear to have been especially relevant for consumers considering the purchase of durable good.”

Once we factor in all this, it is safe to say that the Federal Reserve will go really slow at increasing interest rates. In fact, I don’t see it increasing the federal funds rate to 1.4% by the end of next year. This means good news for Indian stock and bond markets, at least for the time being.
The column originally appeared on The Daily Reckoning on December 18, 2015

Yellen led Federal Reserve will raise interest rates, but very gradually

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Up until now every time the Federal Open Market Committee has had a meeting, I have maintained that Janet Yellen, the Chairperson of the Federal Reserve of the United States, will not raise interest rates. The latest meeting of the FOMC is currently on (December 15-16, 2015) and I feel that in all probability Janet Yellen and the FOMC will raise the federal funds rate at the end of this meeting.

The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.

So why do I think that the Yellen led FOMC will raise the interest rate now? Two major economic indicators that the FOMC looks at are unemployment and inflation. Price stability and maximum employment is the dual mandate of the Federal Reserve.

There are various ways in which the bureau of labour standards in the United States measures unemployment. This ranges from U1 to U6. The official rate of unemployment is U3, which is the proportion of the civilian labour force that is unemployed but actively seeking employment.
U6 is the broadest definition of unemployment and includes work­ers who want to work full-time but are working part-time because there are no full-time jobs available. It also includes “discouraged workers,” or people who have stopped looking for work because the economic conditions the way they are make them believe that no work is available for them.

U6 touched a high of 17.2 percent in October 2009, when U3, which is the official unemployment rate, was at 10 percent. Nevertheless, things have improved since then. In October and November 2015, the U3 rate of unemployment stood at 5% of the civilian labour force. The U6 rate of unemployment stood at 9.8% and 9.9% respectively. This is a good improvement since October 2009, six years earlier.

In fact, the gap between U3 and the U6 rate of unemployment has narrowed down considerably. As John Mauldin writes in a research note titled Crime in the Job Report with respect to the unemployment figures of October 2015: “The gap between the two measures [i.e. U3 and U6] is now the smallest in more than seven years, a sign that slack in the labour market is diminishing. And as the Fed weighs a potential rate hike, what may be more important is the number of people working part-time who would prefer to work full-time – that number posted its biggest two-month decline since 1994. Janet Yellen has referred to this number as often as she has to any other specific number. It is on her radar screen.”

In fact, Janet Yellen seems to be feeling reasonably comfortable about the employment numbers. As she said in a speech dated December 2, 2015: “The unemployment rate, which peaked at 10 percent in October 2009, declined to 5 percent in October of this year…The economy has created about 13 million jobs since the low point for employment in early 2010.

Another indicator that has improved is the number of people who want to work full time but can’t because there are no jobs going around. As Yellen said: “Another margin of labour market slack not reflected in the unemployment rate consists of individuals who report that they are working part time but would prefer a full-time job and cannot find one–those classified as “part time for economic reasons.” The share of such workers jumped from 3 percent of total employment prior to the Great Recession to around 6-1/2 percent by 2010. Since then, however, the share of these part time workers has fallen considerably and now is less than 4 percent of those employed.”

On the flip side what most economists and analysts don’t like to talk about is the fact that the labour force participation rate in the United States has fallen. In November 2015 it stood at 62.5%, against 62.9% a year earlier. It had stood at 66% in September 2008, when the financial crisis started.
Labour force participation rate is essentially the proportion of population which is economically active. A drop in the rate essentially means that over the years Americans have simply dropped out of the workforce having not been able to find a job. Hence, they are not measured in total number of unemployed people and the unemployment numbers improve to that extent.

This negative data point notwithstanding things are looking up a bit. With the U3 unemployment rate down to 5% and U6 down to less than 10%, companies, “in order to entice additional workers, businesses may have to think about paying more money,” writes Mauldin.

And this means wage inflation or the rate at which wages rise, is likely to go up in the days to come. The wage inflation will push up general inflation as well as buoyed by an increase in salaries people are likely buy more goods and services, push up demand and thus push up prices. At least that is how it should play out theoretically.

As Yellen said in a speech earlier this month: “Less progress has been made on the second leg of our dual mandate–price stability–as inflation continues to run below the FOMC’s longer-run objective of 2 percent. Overall consumer price inflation–as measured by the change in the price index for personal consumption expenditures–was only 1/4 percent over the 12 months ending in October.”

But a major reason for low inflation has been a rapid fall in the price of oil over the last one year. How does the inflation number look minus food and energy prices? As Yellen said: “Because food and energy prices are volatile, it is often helpful to look at inflation excluding those two categories–known as core inflation…But core inflation–which ran at 1-1/4 percent over the 12 months ending in October–is also well below our 2 percent objective, partly reflecting the appreciation of the U.S. dollar. The stronger dollar has pushed down the prices of imported goods, placing temporary downward pressure on core inflation.”

In fact, the fall in the price of oil has also brought down the fuel and energy costs of businesses. This has led to a fall in the prices of non-energy items as well. “Taking account of these effects, which may be holding down core inflation by around 1/4 to 1/2 percentage point, it appears that the underlying rate of inflation in the United States has been running in the vicinity of 1-1/2 to 1-3/4 percent,” said Yellen.

In fact, a careful reading of the speech that Yellen made on December 2, clearly tells us that she was setting the ground for raising the federal funds rate when the FOMC met later in the month.

On December 3, 2015, Yellen made a testimony to the Joint Economic Committee of the US Congress. In this testimony she exactly repeated something that she had said a day earlier in the speech. As she said: “That initial rate increase would reflect the Committee’s judgment, based on a range of indicators, that the economy would continue to grow at a pace sufficient to generate further labour market improvement and a return of inflation to 2 percent, even after the reduction in policy accommodation. As I have already noted, I currently judge that U.S. economic growth is likely to be sufficient over the next year or two to result in further improvement in the labour market. Ongoing gains in the labour market, coupled with my judgment that longer-term inflation expectations remain reasonably well anchored, serve to bolster my confidence in a return of inflation to 2 percent as the disinflationary effects of declines in energy and import prices wane.”

This is the closest that a Federal Reserve Chairperson or for that matter any central governor, can come to saying that he or she is ready to raise interest rates. My bet is that the Yellen led FOMC will raise rates at the end of the meeting which is currently on.

Nevertheless, this increase in the federal funds rate will be sugar coated and Yellen is likely to make it very clear that the rate will be raised at a very slow pace. This is primarily because the American economy is still not out of the woods.

The economic recovery remains fragile and heavily dependent on low interest rates. Net exports (exports minus imports) remain weak due to a stronger dollar. Yellen feels that this has subtracted nearly half a percentage point from growth this year.

In this environment economic growth in the United States will be heavily dependent on consumer spending, which in turn will depend on how low interest rates continue to remain. As Yellen said in her recent speech: “Household spending growth has been particularly solid in 2015, with purchases of new motor vehicles especially strong….Increases in home values and stock market prices in recent years, along with reductions in debt, have pushed up the net worth of households, which also supports consumer spending. Finally, interest rates for borrowers remain low, due in part to the FOMC’s accommodative monetary policy, and these low rates appear to have been especially relevant for consumers considering the purchase of durable good.”

This again is a clear indication of the fact that the federal funds rate in particular and interest rates in general will continue to remain low in the years to come.

As Yellen had said in a speech she made in March earlier this year: “However, if conditions do evolve in the manner that most of my FOMC colleagues and I anticipate, I would expect the level of the federal funds rate to be normalized only gradually, reflecting the gradual diminution of headwinds from the financial crisis.”

I expect her to make a statement along similar lines either as a part of the FOMC statement or in the press conference that follows or both.

(The column originally appeared on The Daily Reckoning on December 16, 2015)

Here’s the real reason why US Federal Reserve did not raise interest rates

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The Federal Open Market Committee (FOMC) of the Federal Reserve of the United States, the American central bank, has decided to stay put and not raise the federal funds rate for the time being, as it has for a very long time now.

The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.

The market was split down the middle on what they expected the Federal Reserve to do. The Federal Reserve has maintained the federal funds rate in the range of zero to 0.25% in the aftermath of the financial crisis which started in September 2008. This has been done in the hope of supporting an American economic recovery.

One view was that the Federal Reserve should start raising the federal funds rate now and get done with it. The other view was that the American economy is still in a fragile state and hence, the federal funds rate should not be raised. Also, any increase in the federal funds rate would have a bad impact on financial and asset markets all over the world, this school of thought held. And that couldn’t possibly be good for the American economy.

The FOMC led by the Federal Reserve Chairperson Janet Yellen chose to go with the latter view.  There are several reasons for the same.
The unemployment rate in the United States fell to 5.1% of the civilian labour force in August 2015. Nonetheless, this number does not take into account those who are working part-time even though they want to work full time. It also does not take into account those who want to work but haven’t actively searched for a job recently.

In fact, the number to look at is the labour force participation ratio. The World Bank defines this as: “the proportion of the population ages 15 and older that is economically active: all people who supply labour for the production of goods and services during a specified period.”

The number had stood at 66% in January 2008 before the start of the financial crisis. As of August 2015 it stands at 62.6%. In August 2014 the number was at 62.9%. Hence, the labour force participation ratio has fallen over the last one year, despite the unemployment rate going down. This means that people have been dropping out of the workforce as they get discouraged at not finding a job and then stop looking for it.

Further, the Federal Reserve has been aiming for an inflation of 2%. As yesterday’s FOMC statement said: “the Committee expects inflation to rise gradually toward 2 percent over the medium term.”

The measure of inflation that the Federal Reserve likes to look at is the core personal consumption expenditure (PCE) deflator. The core PCE deflator is at 1.24%, which is nowhere near 2% that the Federal Reserve is aiming for. A stronger dollar which has made imports into America cheaper as well as lower oil prices are the major reasons for the same.

Interestingly, the FOMC in its statement yesterday said: “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” This is the first time this line has made it into the FOMC statement.

What does it mean by this? As Yellen said in a press conference that followed the release of the FOMC statement: “The outlook abroad appears to have become more uncertain of late. And…heightened concerns about growth in China and other emerging market economies have led to volatility in financial markets.”

In the press conference that nobody asked Yellen about what did she really mean by this. Chinese economic growth has been slowing down. Many analysts have argued that China is not growing at the 7% growth rate that it claims to be.

In this scenario it is likely that China might devalue the yuan against the dollar further in order to push up its exports. If China devalues the yuan, Chinese exports will become more competitive as Chinese exporters are likely to cut prices. In this scenario the value of imports coming into the United States will fall further, as exporters from other countries will also have to cut prices in order to compete with the Chinese. This will mean inflation falling further. In my opinion, this is what Yellen and the FOMC really meant.

In the press conference Yellen said that she expects that the FOMC will raise the federal funds rate before the end of this year. The direction in which the Chinese economic growth will unravel is unlikely to become clear so soon.

What this means is that the era of easy money unleashed by the Federal Reserve in late 2008, is likely to continue in the months to come. The Federal Reserve is unlikely to raise the federal funds rate this year. Not surprisingly the stock market in India is having a good day, with the BSE Sensex having rallied by more 470 points or 1.8%, as I write this.

Also, now that the FOMC hasn’t raised interest rates, calls for the RBI governor Raghuram Rajan to cut the repo rate are going to get louder.

The column originally appeared on Firstpost on Sep 18, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)