The statement by the Federal Open Markets Committee after its meeting this week and the accompanying projections indicate that the impact of the Russia-Ukraine conflict on the global economy is going to be quite severe. While the Federal Reserve was relatively sanguine in the February meeting, despite the fast increase in Covid-19 cases due to the Omicron variant, it sounded distinctively hawkish in the meeting this week, bringing about large revisions to its projections as well as its rate hike trajectory. The median projection for real GDP growth for 2022 has been marked down from 4 per cent in the December meeting to 2.8 per cent now while the PCE inflation projection has been revised higher from 2.6 per cent to 4.3 per cent. The Federal Reserve has however made it clear that price stability is the key to fostering growth and ensuring maximum employment and has therefore taken a rather aggressive stance to tame inflation. In the December meeting, the median projections indicated three policy rate hikes of 25 basis points each in 2022 and 2023. But the forecast now indicates 6 to 7 hikes of 25 basis points each in 2022 alone, taking the policy rate to 1.9 per cent by the end of this year. This is to be followed by four similar rate hikes in 2023.

The reason why the Fed is able to proceed in this aggressive manner towards inflation control is because it is fairly confident that growth will be robust in the US, higher than 2.5 per cent, led by the strong demand conditions in the economy. Employment conditions are also quite healthy with strong demand for labour and large wage hikes. These signs of revival are also prompting the Fed’s move towards reducing the surplus liquidity in the market and to begin shrinking its balance sheet as well. The Fed has indicated that it will begin reducing the outstanding bonds on its balance sheet in the coming months. The consequential reduction in liquidity in the system is also expected to help contain inflation. Financial markets seem to have been enthused by the Fed’s view on growth and the prospect of lesser supply of US treasury securities. But the full impact of the Fed’s actions could be felt over the coming months as the finance cost of leveraged trades moves higher, impacting financial market trades. Savers in US, who have been faced with negative real returns on their fixed income investments would however be heaving a sigh of relief now.

The Reserve Bank of India may soon have to follow in the Fed’s footsteps and will have to acknowledge that inflationary pressure is larger and longer lasting than originally expected. With the war only heightening the price pressures in the economy, all eyes are on how the central bank will react. . Rising inflation will result in demand destruction which in turn will peg growth lower. Of course, it is true that inflation is now driven by the import channel through crude oil and other commodities which means that monetary policy will be a blunt instrument to wield; what’s needed are fiscal measures such as cuts in duties to control prices. RBI’s actions should be carefully thought out as precipitate action can prove counter-productive and end up hurting growth.

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