US Fed 75bp rate hike: What monetary policy issues will RBI Gov Shaktikanta Das face now?

Reserve Bank of India (RBI) Governor Shaktikanta Das will be most concerned about the US Federal Reserve’s decision to raise short-term rates by 75 basis points to 2.25-2.50%.

This unanimous 75 basis points has been almost priced in by the US market, but the firm commitment to bring inflation down to 2% sets the stage for further hikes in the near future, which will worry emerging markets like the India. The American Fed, very late on the curve, said today that it was very attentive to the risks of inflation. Fed Chairman Jerome Powell said they were also continuing the process of significantly reducing the size of its balance sheet.

Rising interest rates in the US present challenges for the RBI governor as domestic inflation shows signs of receding. The new inflation path calls for a 35 basis point hike in the repo rate in August to support growth, but narrowing interest rate differentials between the US and India call for a more aggressive hike, however. 50 basis points to support the currency.

Indeed, the interest rate differential, which was around 3.75% between the United States and India during the two years of the pandemic, has now fallen to 2.40%. This will discourage foreign portfolio investors from placing funds in Indian debt and equity markets.

CPI, or retail inflation, was 4.35% in September last year, but has risen sharply this year, reaching 6.95% in March and 7.79% in April. The CPI is beginning to decline due to a slight easing in commodity prices globally. In May it fell to 7.04% and to 7.01% in June. The RBI Governor has publicly stated that inflation appears to have peaked.

Currently, headline inflation and core inflation in India are well below those of the US and UK in terms of targeted inflation. The Indian central bank’s inflation target is 4% (7% real inflation). In June, inflation reached 9.1%, exceeding the target of 2%. Inflation in the UK hit a 40-year high of 9.4%. Given the low inflation target of 2%, global central bankers will have to resort to more rate hikes to keep inflation under control.

Rising interest rates globally have already led to capital flight from emerging markets like India. This outflow of dollars is already strengthening the value of the dollar. A weakening rupee actually creates a new headache for RBI as imported inflation further fuels the fire of inflation.

Jeffrey Halley, Senior Market Analyst, Asia-Pacific, OANDA, a global financial services firm, believes the RBI will use the opportunity to really push for inflation to be below target. “Furthermore, the weakness of the Rupee will play into their minds which leaves them with no leeway to ease policy. As such, I expect the RBI to maintain firm monetary policy settings” , Halley said.

The yield gap between India and the United States is not expected to change significantly, according to Arvind Chari, CIO of Quantum Advisors.

Repo rate hike forecasts are 35 to 50 basis points in August policy. “This would mean that Indian short-term rates will rise and therefore we do not expect major changes in the yield differential between India and the United States,” Chari said.

Chari says India’s inflation and growth trajectory is very different from that faced by developed economies. “The United States, pushed by monetary and fiscal stimulus, is facing tough labor conditions and, beyond the supply disruption, is also experiencing genuine demand and wage-driven inflation. So in the United States, you would see the Fed continuing to raise and raise short-term interest rates,” Chari says.

Also read: US Fed opts for 75 basis point rate hike as flags weaken economic data

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