The Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) decided to retain the federal funds rate close to zero, but there were two significant changes in the December policy. One, the FOMC appeared more assured about the growth prospects. The Fed Chairman Jerome Powell was quite categorical when he stated in the post-policy press conference that economic activity is on track to expand at a robust pace this year and that aggregate demand is very strong due to monetary and fiscal policy support and healthy financial position of households and businesses. Two, the Fed finally dropped the word ‘transitory’ while discussing inflationary concerns and acknowledged that inflation could last longer and be more widespread than originally anticipated. These two factors were cited as the reason why the Fed accelerated the reduction in monthly bond purchases and plans to halt these purchases completely by mid-March 2022. Of greater interest to financial markets is the median projection of at least three 25 basis points policy rate hikes in 2022 by the FOMC, to take the Fed fund rate to 0.9 per cent by the end of next calendar. This is much higher than the projection of just one rate hike in 2022 made after the September policy. While the Fed has stated that its future actions will be contingent upon economic data and progress of the pandemic, its altered position will wield an influence on policy actions of the RBI.
Many central banks, including the RBI, have been taking the cue from the Fed in underplaying the threat from inflation, reiterating that rising prices were due to supply chain bottlenecks caused by the pandemic which will ease soon. But the Fed has now acknowledged that these problems are larger and longer lasting than it originally anticipated, and that inflation is now spreading to all sectors of the economy. While the labour market conditions have shown strong growth in the US, with unemployment declining to 4.2 per cent in November, the Fed is worried about sharp increase in wage growth further stoking inflationary pressure. The median projection for PCE inflation for 2022 has been revised higher to 2.7 per cent, up from 2.3 per cent projected in the September policy meeting. Inflation is expected to decline towards the long-term goal of 2 per cent, only in 2024.
Given the revised view on inflation, the Fed is likely to be quite aggressive in its future monetary policies. The RBI will now have to seriously review its stance on inflation; whether any corrective action is required before growth is destabilised by rising prices. Sticky core inflation in India, above 6 per cent, indicates that RBI may have to act soon. The other reason why the Fed action will be of relevance to the RBI is because higher interest rates in the US will narrow the spread in real interest rates between the two countries. If Indian government securities become less attractive, foreign funds could pull out more money out of Indian bond markets, exacerbating rupee weakness.
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