Fed in focus: Lower interest rates alone may not aid capital flows to India

The outcome of the Federal Open Market Committee (FOMC) meeting of the United States Federal Reserve is always closely watched by financial markets across the world, but the interest this time was much higher than usual. In terms of policy action, the Fed decided to lower the target range for the federal funds rate by 25 basis points to 4-4.25 per cent on Wednesday, as was widely expected by financial markets. However, there was significant interest in how the FOMC voted on the policy decision and the future expectations. White House Economic Adviser Stephen Miran was confirmed by the Senate on Monday to the Federal Reserve board, just in time to be able to attend the FOMC meeting, which began on Tuesday. Mr Miran is now on leave from the White House and may go back to that position once his term expires. This is an unusual position in modern central banking, and particularly for the Fed. As many in the market had anticipated, Mr Miran dissented from the majority and wanted a deeper 50-basis-point cut.

 

Nevertheless, Mr Miran’s presence is not the only unusual thing for the Fed at the moment. In fact, his position at the Fed is part of a bigger plan. The Fed and its chairman, Jerome Powell, have been under attack from US President Donald Trump for not lowering interest rates quickly enough. Mr Trump also attempted to remove Lisa Cook, one of the Fed governors. However, the courts have allowed her to continue in her position and participate in the FOMC meeting. Mr Trump is seeking to have a greater say in the workings of the Fed, if not directly control it. A lot in financial markets over the medium term will depend on how this plan goes.

 

An independent central bank has long been the centrepiece of the US financial system, which has a far-reaching significance for global financial markets and capital flows. A loss of confidence in the Fed or the broader US markets can quickly unsettle global financial markets with longer-run consequences. The Fed will thus be watched much more closely by global financial markets. In terms of near-term possibilities, the projections released by the Fed suggest that it could cut the federal funds rate by 25 basis points each in the two remaining meetings this year. This would be followed by another cut next year. The decision to reduce the policy interest rate has been explained by the weakness in the labour market. In terms of inflation outcomes, the projection for 2026 has been increased by 20 basis points to 2.6 per cent over the June projection, which is much higher than the Fed’s medium-term target of 2 per cent.

 

It remains to be seen how the impact of tariffs plays out in terms of inflation outcomes. Potential stickiness in inflation outcomes could become challenging for the Fed in the coming quarters. However, for now, financial conditions should be expected to ease. The yield on 10-year US government bonds, for instance, has come down by over 20 basis points this month. Theoretically, relatively easy global financial conditions should help improve financial flows to India. However, capital flows in the coming months will also be determined by the progress in trade negotiations between India and the US. A favourable trade deal, along with lower interest rates in the US, will significantly reduce uncertainty for the Indian economy and financial markets in the near term.