Inflation-currency conundrum

Higher US inflation can increase currency volatility

The consumer price index (CPI)-based inflation rate in the US for August increased at the fastest pace in over a year, indicating that the last leg of the Federal Reserve’s inflation battle would not be easy. The annual rate came at 3.7 per cent, up from 3.2 per cent in July. Although the headline rate was partly driven by higher fuel prices, core inflation also witnessed a sequential uptick. In its combat against inflation, the Fed has raised its benchmark policy rate range to 5.25-5.5 per cent, the highest in over two decades. While financial markets expect the Fed to leave the policy rate unchanged at the upcoming September meeting, analysts are expecting one more rate increase in the current cycle. However, irrespective of when the Fed delivers the next policy rate increase — given that it would want to see the inflation rate coming down convincingly near the target of 2 per cent — interest rates are likely to remain elevated for some time.

The possibility of the US policy rate remaining higher for longer will have implications for both the US and global markets. Although the US economy has  remained fairly resilient thus far, economists expect weakness ahead. Further, sustained higher US interest rates for a relatively long period will have implications for capital flows and currency markets. The Chinese yuan, for instance, last week dropped to its lowest in over a decade against the US dollar. The currency has since recovered with reported support by the Chinese central bank. To be sure, the yuan is also reflecting the weakness in the Chinese economy. The downturn in the real estate market, along with several other sectors, is affecting the growth prospects. Besides, after contracting in July, the retail inflation rate for August stood at a modest 0.1 per cent.

The Chinese central bank is supporting the economy with monetary accommodation. However, in a world of higher interest rates, mobile capital would prefer to leave Chinese shores for higher-yield markets. Global fund managers are reported to be looking for alternatives, which could benefit India. Meanwhile, the Japanese yen is also under pressure, partly because of the rate differential. The 10-year Japanese government bonds yield about 0.7 per cent, compared to the yield of 4.3 per cent in US government bonds of the same maturity. Yields at the shorter end of the curve in the US are even higher. Given the rate differential, the currency market is expected to witness bouts of volatility. The dollar index has gone up by about 5 per cent since mid-July.

Where does all this leave India? Data released this week showed the retail inflation rate in India moderated in August to 6.8 per cent from 7.4 per cent the previous month, mainly due to a moderation in food prices, but remained significantly above the upper end of the Reserve Bank of India’s tolerance band. While the RBI’s monetary policy committee decided in its last meeting to sit through the inflation spike, driven largely by food prices, sustained higher cereal inflation could create complications. Furthermore, crude oil prices have gone up significantly and are expected to remain elevated. This could impart additional pressure on the headline inflation rate. Higher oil prices would also widen the trade deficit. Although the rupee has remained fairly stable in the recent period, given the broader economic backdrop and volatility in currency markets, it can be expected to witness downward pressure.