The US Federal Reserve raised interest rates by 25 basis points on Wednesday, its first increase since 2018, and outlined an aggressive monetary policy stance that includes balance sheet reduction to combat record-high inflation. The Fed projected that its policy rate would reach a range of 1.75 percent to 2% by year’s end, arguing that the rate increases would be necessary to rein in inflation, which reached a 40-year high of 7.9 percent in February. Additionally, it cited the Ukraine war as exerting upward pressure on inflation, as global commodity prices remained elevated.
Federal Reserve Chairman Jerome Powell stated during a press briefing that inflation is expected to begin slowing in the second half of the year and eventually fall to the Federal Reserve’s target level of 2% by 2024. Even with a less accommodative monetary policy, the robust US economy should be able to expand. “All indications are that this is a robust economy, one that will thrive, not necessarily withstand, but certainly thrive in the face of less accommodative monetary policy,” he said.
How has the Federal Reserve’s rate hike impacted financial markets?
Markets reacted positively to the world’s largest central bank’s clear path, with US markets closing higher by 2% and Indian stock markets opening with a more than 1% gap on Thursday. Commodities retreated, with Brent crude oil falling and remaining below $99 per barrel, a significant decline from the recent high of $139 per barrel.
Going forward, Indian and global markets are expected to remain optimistic as three major uncertainties have passed — Assembly elections in five Indian states, the US Federal Reserve’s decision, and signs that the Russia-Ukraine conflict is entering a resolution phase. Any increase in commodity prices could result in equity market corrections, even if the broader trend of rising stock prices continues.
What effect will it have on the RBI’s policy decision?
The Federal rate hike decision and rising domestic retail inflation will have a direct impact on the Reserve Bank of India’s monetary policy review at its next Monetary Policy Committee meeting, scheduled for April 6–8, 2019. Unlike the US Federal Reserve, which has clearly abandoned its accommodative monetary policy, the RBI maintains an accommodative stance. This is partly because retail inflation in India has remained within the RBI’s target range.
Domestic retail inflation increased to an eight-month high of 6.07 percent in February, breaching the medium-term inflation target of 4+/- 2 percent for the second consecutive month.
According to some economists, the RBI may need to revise its inflation forecast upward as inflationary pressures become more widespread. A reassessment of the central bank’s current accommodative stance is also possible. This is the fifth month in a row that inflation has increased. In January 2022, retail inflation was 6.01 percent, up from 5% a year ago. The RBI forecasts retail inflation of 5.3 percent in FY22, 5.7 percent in Q4, and 4.9 percent in Q1 FY23.
What will be the consequences of the RBI’s inflation target being breached?
According to the Finance Ministry, two consecutive months of retail inflation above 6% cannot be interpreted as a breach of the upper band of the RBI’s target, and crossing the 6% band “for a particular month cannot be interpreted as a breach of the target.”
“Breach of this inflation target is defined as (a) average inflation is greater than the inflation target’s upper tolerance level for any three consecutive quarters; or (b) average inflation is less than the inflation target’s lower tolerance level for any three consecutive quarters,” the ministry states. As a result, the RBI has room to maintain its current stance, despite some risks associated with elevated commodity prices. The fact that Brent crude oil has fallen sharply below $99 per barrel should provide the central bank with additional comfort.
Additionally, some policymakers believe that because fiscal policy is in “contraction” mode, monetary policy must remain accommodative. The government has set the fiscal deficit for 2022-2023 at 6.4 percent of GDP, down from 6.9 percent in 2021-22 and 9.2 percent in 2020-21.
“From 9.2 percent, the fiscal contraction next year will be almost 3%, which is a significant contraction. When fiscal policy is in contraction and private consumption remains below pre-crisis levels, monetary policy must remain accommodative,” an official explained, indicating why the government expects the RBI to maintain an accommodative monetary policy stance.