Borrowing costs

View: Fed action has implications for India’s budget, such as higher borrowing costs for the Indian government

Easy no longer does this for the US central bank, the Federal Reserve. In the highly anticipated January 26 monetary policy announcement, Fed Chairman Jerome Powell made it clear that he was pulling out the proverbial big bazooka to bring down inflation in the United States.

To be fair, it didn’t quite come out of nowhere. Consumer inflation in the United States is at its highest level in 40 years – well five percentage points above the average level of 2% that it is targeting – and the Fed has, in recent months, is doing its best to prepare the markets for an aggressive tightening . The assertion in Wednesday’s announcement that it would raise the benchmark policy rate, the federal funds rate, as early as March was widely anticipated and priced in to asset prices, whether equities, bonds or commodities.

There was, however, a googly. Financial markets gauge how many times a major central bank is likely to raise its policy rate. They had forecast four rate hikes of a quarter of a percentage point each for 2022. The aggressiveness of the Fed at this week’s meeting now leads them to forecast five hikes or even more. Powell did not rule out the possibility of a hike at every monetary policy meeting. There are seven left for the year. For those wondering what it’s all about, the yield on US 10-year bonds is trading at less than 2%. So even a quarter percent increase in the policy rate makes a significant difference.

The Fed maintained its commitment to end bond purchases by March. For those unfamiliar with these monetary machinations, the Fed had countered the economic fallout from the pandemic by injecting $120 billion of liquidity into the financial system each month since 2020. It did so through a simple purchase transaction. government and mortgage bonds with newly minted dollars. . As the US economy stabilized and inflation became more of a concern, the Fed in December decided to reduce these purchases to zero.

He also discussed the possibility of sucking up cash by selling, rather than buying, bonds, a move just as crucial to financial markets as rate hikes. The Fed, thankfully, did not announce a timeline for this process on Wednesday. A rapid withdrawal of liquidity would have added to the woes of the global financial system. However, he made it clear that this would follow reasonably shortly after the interest rate hike. This sword weighs on world markets.

What does this mean for India? Well, there’s no point in pretending that the Fed’s “warmongering pivot”, to use Wall Street gibberish, won’t impact India’s financial system. The Fed is, after all, the parent central bank, and financial markets and policymakers tend to throw tantrums first and then listen to Mom when she raises her voice.

Tantrums could mean increased selling pressure in stock and bond markets, and some cooling in seemingly overheated commodity markets. The rupee might depreciate a bit. In the long term, central banks should lean in the direction of the Fed. Thus, domestic interest rates in India are expected to rise.

However, the RBI need not mimic the Fed and go into a hyper-aggressive mode. There are stark differences in the economic fundamentals of the US and India – the obvious being in the levels of inflation. While December’s US consumer inflation figures were well above the Fed’s target, India’s inflation is well within its 2-6% tolerance range. While the current quarter could see local inflation close to 6%, most forecasters predict a gradual moderation going forward.

Second, apart from the supply disruptions that have affected the price line in the United States, it is a fairly tight labor market and an upward spiral in wages. Wages and prices tend to feed off each other. Long-term high inflation is the inevitable consequence. Labor shortage, on the other hand, is hardly a problem in India. Apart from certain pockets where there is a chronic shortage of workers and managers, there is no reason to fear wage inflation.

Finally, there is the matter of what is euphemistically called the question of political economy – or, to put it more bluntly, the pressure from the White House to use a sledgehammer to make lower prices. U.S. midterm elections to its house of Congress – roughly the equivalent of India’s parliament – are scheduled for November. Joe Biden’s approval ratings are plummeting, and unless Washington is able to cut the cost of living, it could be a blow for Republicans. Thus, Powell’s hard line may reflect the demands of realpolitik rather than a pure economic imperative.

That doesn’t mean the RBI can sit on its hands. It is already reeling from domestic liquidity and rate hikes are expected during the year. However, the constant warning from some quarters that India’s central bank has lagged the curve – a view believed to be influenced by Fed actions – is somewhat unfair.

The global liquidity pivot also has implications for the upcoming budget. Government borrowing costs are likely to rise for one. With combined central and state government debt reaching 90%, Nirmala Sitharaman will need to cut the deficit significantly to avoid a long-term spiral in government interest payments. Increasingly cheaper global liquidity could also have negative effects on the divestment plan.

That said, budgeting isn’t easy, even at the best of times. The only way to find a way through the maze of trade-offs is to focus on the basics – promoting job-intensive investment, providing targeted assistance to segments most affected by the pandemic, and getting the ball rolling on pending plans like bad bank, development finance institution and asset monetization pipeline.