Fighting inflation

Synchronised rate hikes by large central banks would increase financial stability risks

The global fight against high inflation continues. The Federal Open Market Committee (FOMC) of the US Federal Reserve, as widely expected, raised the policy interest rate or the federal funds rate for the fourth consecutive time by 75 basis points on Wednesday. The US central bank is raising rates at the fastest pace since the 1980s to contain inflation, which is at a near four-decade high and considerably above the medium-term target of 2 per cent. The rate was at 8.2 per cent in September. While the Fed is determined to bring down the inflation rate closer to its medium-term target, financial markets around the world are grappling with two extremely important questions. First, how soon will the Fed lower the pace of rate hikes, and, second, what would be the terminal funds rate for the current cycle? The Bank of England also raised interest rates by 75 basis points on Thursday.

Financial markets on Wednesday initially got the impression that the pace of rate hikes would now come down as the FOMC in its statement noted that in deciding future rate hikes, it would take into account the cumulative policy tightening. However, clarifications by Fed Chair Jerome Powell suggested it may not be a done deal yet, which led to a sharp sell-off in the stock market. Mr Powell also argued the more important questions at the moment were to what extent rates would need to be increased, and for how long monetary policy will need to be restrictive. Thus, it is likely that even if the pace of rate hikes moderates in the coming meetings, the terminal rate will be higher than what was anticipated until recently. The Fed is of the view that the risk of over-tightening is better than under-tightening.

Given the state of the US labour market, which is extremely tight, inflation is expected to remain elevated for some time. According to one estimate, the core inflation rate is expected to stay above 6 per cent at least until the first quarter of next year. The level of disinflation required suggests financial conditions would be tightened significantly and rates will remain elevated for quite some time. This could significantly increase risks in global financial markets. Sustained capital flows to the US could further increase volatility in currency markets and perhaps require higher than desired monetary tightening in some economies. Synchronised rate hikes by large central banks would also increase financial stability risks.

The Indian central bank is also increasing interest rates to contain inflation, which has been above the tolerance band for three consecutive quarters and is being regarded as a failure to attain the inflation target. The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) met on Thursday to draft a letter to the government as mandated by the law, explaining the reasons for its failure. The government would be well advised to make it public at the earliest. The RBI has argued that early tightening of policy would have affected growth. It’s worth noting that the RBI started late because in its assessment higher inflation since the outbreak of the pandemic was transitory. Nevertheless, continued tightening by large central banks, particularly the Fed, would increase complications for the MPC. Although its mandate is domestic price stability, it may have to account for the possibility of large capital outflows and currency market volatility because they will have implications for inflation outcomes.