Focused Fed

For emerging markets such as India, there’s little to cheer in the US Federal Open Market Committee’s (FOMC’s) decision to hike policy rates by 75 basis points for the second time, while indicating that further increases are on the cards. But both the US stock and bond markets made dovish inferences from the event to register strong gains; the Indian markets have followed suit. The FOMC and Chairman Jerome Powell made it clear that, between their commitment to push US inflation back to the targeted 2 per cent (the latest June print was 9.1 per cent) and the need to keep economic growth alive, they saw the former as their more urgent imperative. In his post-meeting interaction, Powell stated that until the Fed had ‘compelling evidence’ that retail inflation was returning to 2 per cent, ‘ongoing increases’ would be the norm, with another ‘unusually large increase’ in September not ruled out. But his observation that there were already signs of a slowdown in US economy and that the quantum of future rate hikes would be data-dependent, seems to have buoyed markets.

Though quarterly GDP data released a little after the FOMC announcement showed that US may have entered a technical recession, Powell played down the significance of provisional numbers and pointed to record monthly payroll additions and the 50-year low unemployment rates as signs of a still strong economy. Overall, the Fed’s unambiguous stance on doing whatever it takes to quell inflation, does raise risks of the US ending up in a more severe slowdown a few months down the line. Despite the apparent strength in US job markets, it is moot if stringent monetary measures alone can quell the current bout of inflation which has its origins in geopolitical, supply-side issues. Sticky inflation is already putting pressure on spending by US lower-income households. With US mortgage rates up by a steep 150-200 basis points in the last four months, there are worries that homebuyers may begin to default a few months down the line. The inverted yield curve suggests that US bond markets do expect a recession.

It is early days yet to worry about the impact of a possible US recession on India. But the Fed’s plans to continue with significant rate hikes for the foreseeable future, do put the Reserve Bank of India in a piquant situation on its ability to strike a balance between growth and inflation considerations. With the June CPI reading at 7.01 per cent, India’s retail inflation is closer to the central bank’s comfort zone of 2-6 per cent. RBI has also pointed to the likelihood of domestic inflation cooling on the back of a normal monsoon and the recent declines in global commodity prices. All this had led to expectations that the RBI would pause or calibrate its rate hikes in its upcoming reviews. But as a recent Bank of America report notes, India’s policy rate differential with the US, before the latest hike, was at just 315 basis points against the long-term average of over 510 basis points. US Fed action, with its implications for foreign portfolio flows and the rupee, may now force RBI’s hand on future hikes. The only silver lining is that the RBI appears to be well aware of this dynamic and has initiated several non-monetary measures such as incentivising NRI deposits and FPI debt flows to shore up the rupee.

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