Last-mile challenges

US inflation is altering expectations

Assessing the trajectory of inflation has become increasingly challenging. The US Federal Reserve, along with several other central banks in both advanced and developing economies, for instance, believed that the increase in consumer prices in the aftermath of the pandemic was transitory in nature. However, sustained high inflation rates eventually forced them to adjust, which led to a sharp and coordinated increase in policy rates across most parts of the world in 2022, resulting in a significant tightening of global financial conditions. Higher interest rates did have an impact and inflation rates gradually came down. This led to optimism in financial markets that the Fed will soon start reducing the policy rate. Even the Fed’s own projections — released after the March meeting of the Federal Open Market Committee (FOMC) — indicated that it was on course to reduce the federal funds rate by 75 basis points in 2024.

However, an uptick in the inflation rate to 3.5 per cent in March compared to 3.2 per cent in the previous month has again raised questions regarding how soon it will align with the Fed’s medium-term target of 2 per cent. Fed Chairman Jerome Powell indicated last week after the FOMC meeting that the policy interest rate would likely remain higher for longer. He added the data thus far this year had not given confidence. Mr Powell also noted the Fed’s next move was unlikely to be an increase in interest rates, which led to a short relief rally in financial markets. To be fair, most market participants do not expect the Fed to increase the policy rate, but the last-mile disinflation could become tricky and require adjustments in market expectations. Yields on 10-year US government bonds have increased by about 30 basis points since March end. The renewed expectations of higher for longer will have implications for the US and the rest of the world.
 

The US economy has shown much greater resilience in recent years than anticipated by most analysts. The International Monetary Fund, for example, recently revised its US growth projection for the current year by 60 basis points. But restrictive monetary policy for an extended period can start affecting output, with implications for global growth. Higher US interest rates for a longer period would also induce volatility in international currency markets. The Japanese central bank, for example, intervened at least twice last week to support the yen after it fell to a 34-year low. Several currencies, particularly in the developing world, are likely to face more pressure.
 

What would this mean for India? Pressure on US and global growth would affect output in India through the trade channel. However, on the currency front, India is relatively well placed, reflected by the stability of the rupee in the recent period. The rupee has depreciated about 2 per cent against the dollar over the past year. While higher for longer increases risks for capital flows, it may not lead to large outflows, given India’s growth outlook and relative interest rates. Potential shifts in expectations should also not affect monetary policy decisions. The Monetary Policy Committee (MPC) expects the inflation rate to average 4.5 per cent this financial year, which will be above the target of 4 per cent. Given better than expected growth outcomes, there is no pressing need for the MPC to reduce the policy rate soon.