The next phase

Global financial conditions would tighten further

Higher than expected softening in the inflation rate had raised expectations among market participants in the US that the Federal Reserve (Fed) would soon end the rate-increasing cycle. The inflation rate in the US eased to 7.1 per cent in November as against 7.7 per cent in October. However, the markets would have to adjust expectations. While the Fed delivered the federal funds rate hike of 50 basis points on Wednesday, which was lower than the previous hikes of 75 basis points, and was on expected lines, its Chairman Jerome Powell made it clear in his post-policy press interaction that the US central bank was in no hurry to stop. He noted the Fed would need more evidence to believe that the inflation rate would fall in a sustained manner.

It is worth noting that the inflation rate is still significantly above the Fed’s medium-term target of 2 per cent. Mr Powell also underlined that the Fed had covered a lot of ground, but it needed to do more. The latest economic projections released by the Fed suggest that the federal funds rate would go up to 5.1 per cent compared to the September projection of 4.6 per cent. Differently put, the policy interest rate in the US could still go up by another 75 basis points. The Fed policymakers expect the rate to come down in 2024. Thus, rates becoming lower in 2023, as some in the markets were expecting, may not happen. Continued rate tightening by the Fed, along with the ongoing reduction in its balance sheet size, would further squeeze financial conditions. Rate action by other large central banks such as the Bank of England and European Central Bank would add to the overall tightening of global financial conditions. Both increased rates on Thursday.

Policymaking has now moved to a new phase where central banks would increase rates at a slower pace but are likely to keep them at higher levels till inflation is convincingly contained. Higher interest rates and tighter financial conditions would affect growth and, as a result, a large part of the developed world is expected to slip into a recession. Weaker global demand would weaken inflation, though it remains to be seen how long it takes to come closer to the target. A lot will depend on how inflation conditions evolve in the US because the actions of other central banks will be influenced by the Fed’s stance. As things stand today, the labour market in the US is very strong and wage growth could keep inflation elevated for some time.

The retail inflation rate in India also softened to an 11-month low in November and came below the upper end of the tolerance band of the Reserve Bank of India (RBI). The RBI raised the policy rate by 35 basis points last week, taking the total increase to 225 basis points in the current cycle. While the inflation rate has eased, it is still significantly above the target of 4 per cent. Also, it was driven largely by vegetable prices and core inflation still remains a worry. Thus, the RBI is some distance away from the terminal rate. Given the global policy outlook, it would need to remain prepared to handle bouts of volatility in the currency market. The bigger challenge for Indian policymakers, however, would be to push growth over the next few quarters.