Warsh on the job

The Federal Open Market Committee (FOMC) of the United States (US) Federal Reserve on Wednesday increased the target range for the federal-fund rate by a quarter of a percentage point to 3.75-4 per cent. Given that financial markets had priced in about a 90 per cent chance of a rate increase, the decision hardly surprised anyone. Although the FOMC’s decision was unanimous, it can be seen as another step in establishing Fed Chairman Kevin Warsh’s independence in leading the most important central bank in the world. Many had raised doubts a few months ago over his appointment, questioning whether he would follow President Donald Trump’s line on interest rates. Mr Trump has long argued for lower interest rates. Although he did not really criticise the decision this time, his comments are unlikely to make life any easier for Mr Warsh. Mr Trump said he told Mr Warsh that he might vote with the board because it would not matter, and that the board was very hostile. 

The case for a rate hike was building for quite some time. The outlook on inflation has worsened with increased uncertainties in West Asia and higher energy prices. In any case, the US inflation rate has been running above the 2 per cent target for over five years, and the Fed is expected to raise the policy interest rate further. It is worth noting that a Fed rate adjustment doesn’t usually end with one increase. Interestingly, Mr Warsh said in the post-policy news conference that the Fed had removed a “dose of accommodation”. However, he did not answer whether the rate was now close to “neutral” and noted that it was an academic matter. A neutral rate is the real interest rate that is neither accommodative nor restrictive. The Fed board members’ economic projections, also released on Wednesday, showed that they expected another rate increase this year, and the inflation rate was expected to remain above target even next year. Although the US inflation problem predates the crisis in West Asia, future rate action will, to an extent, depend on what happens in the region. It is also worth noting that the Fed is not alone in this fight against inflation. Last week, the European Central Bank raised interest rates for the second time this year. The Bank of Japan (BoJ) is expected to follow on Friday. There is considerable pressure on the yen, and thus, the BoJ’s decision will be keenly followed across the world. 

An environment of increasing global interest rates tends to create macroeconomic management difficulties in emerging market economies that depend on foreign capital to supplement domestic savings. A higher cost of funds in advanced economies, particularly the US, affects capital flows and tightens global financial conditions. Even before the Fed action, market interest rates had moved considerably. The yield on the 10-year US government bond has increased by about a percentage point since the beginning of the West Asia crisis, and higher inflation is not the only factor driving it. Higher demand for funds by both the government and the private sector, particularly companies in artificial intelligence-related businesses, is pushing up yields. All this has put considerable pressure on the rupee. Faced with the prospect of another year of a deficit in the balance of payments, India mobilised funds under a concessional swap scheme. The response has been encouraging, but the Reserve Bank of India would do well to use this buffer judiciously. Global uncertainty and interest rates may remain elevated for some time. Inflation projections also demand monetary tightening in India, which could help improve the yield differential, though it may not be sufficient to attract adequate capital flows given the global circumstances.