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Here are the clues that RBI, others can draw from the US Fed action

Madan Sabnavis/ 14 Jun 18 | 12:08 PM

US Fed chief Jerome Powell

The rate hike effected by the US Federal Reserve on Wednesday was more or less expected, and it will be so every time the Federal Open Market Committee (FOMC) meets in 2018. It is now well known that inflation is to be in the region of 2 per cent with growth picking up and unemployment coming down. The important message to be taken from the statement was the forward-looking one on future rate cuts. With the indication now of four rate hikes for the year, and with two having been announced so far, we expect the rate to now end at 2.25-2.5 per cent by the year-end.

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The curious thing here is that with inflation at 2 per cent, the real rate would be in the negative territory, unlike in India, where the repo at 6.25 per cent and inflation close to 5 per cent maintains a real interest rate of 1.25 per cent. Quite clearly, the two central banks look at things in a different manner.

The other interesting comparative judgement is in the area of factors being delineated for inflationary expectations. In case of Fed, it is on the demand side, where an increase in government spending and cut in taxes is supposed to generate demand-side forces for inflation, which the Fed rate is out to counter. For us, the inflationary threats are on the cost side, with oil, monsoon, MSP and house rent playing an important role. While the fiscal slippage scenario has been mentioned by the RBI, the emphasis is on supply-side factors.

What does this mean for India now? First, the Fed rate moving up means the US economy will keep growing stronger; that is good from the point of view of exports, but US President Donald Trump’s recent statement accusing India of not being a fair player in global trade could arguably exert some countervailing force. Second, higher rates in the US mean that the dollar is only going to strengthen, implying all global currencies will weaken, unlike in 2017, when this external factor helped in currency appreciation. We should be prepared for a rupee decline this year. A rate of Rs 67.5-68 per dollar looks likely in the absence of any radical shock.

Third, higher rates and strong infra spending in the US will influence global flows of foreign investment. As returns in the US increase the possibility of carry trade reducing, there will be an impact on FPI flows to India. Also, FDI will be impacted as investment opportunities become clearer in the west. Therefore, the continued support from foreign investment for India will be limited this year. The negative flows witnessed in FPI in this financial year are a manifestation of this trait already.

Fourth, with the RBI also looking closely at the Fed moves, as well as those of the ECB, proactive and aggressive monetary policy will be supported by these factors. CPI inflation will remain the guiding force. This means that the RBI would be in a position to increase rates further this year to address concerns on inflation and currency so that the slowdown in FI flows is contained. This means that the GSec yields will remain high and with another rate hike coming from the RBI this year, it would cross the threshold of 8 per cent in a semi-permanent manner.

Hence, the Fed action and tone of statements will continue to be read closely by the RBI in the coming months for sure.

The author is Chief Economist at CARE RatingsDisclaimer: Views expressed are personal. They do not reflect the view/s of Business Standard.

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