Markets
Hawkish to dovish: Fed softens, RBI contemplates
Summary
The Fed’s commitment to price stability means the possibility of another rate hike this year is open. In fact, prior to the July meeting, the Fed dot plot projections were pencilling in two more rate hikes for 2023.
After a brief pause last month, the US Federal Reserve (Fed) has hiked its policy rate by 25 basis points (bps). The federal funds rate now stands at 5.25-5.50%, the highest since 2001. The Fed’s rate decision is not surprising. Despite the recent drop in inflation in the US, it continues to remain above the central bank’s 2% target. Also, the labour market continues to remain tight.
The Fed’s commitment to price stability means the possibility of another rate hike this year is open. In fact, prior to the July meeting, the Fed dot plot projections were pencilling in two more rate hikes for 2023.
Nevertheless, there have been indications that the Fed is increasingly becoming data-dependent and following a ‘meeting by meeting’ approach. For instance, the central bank in the July meeting said, “Looking ahead, we will continue to take a data-dependent approach in determining the extent of additional policy firming that may be appropriate." This contrasts with the rhetoric in the June meeting, “Nearly all committee participants view it as likely that some further rate increases will be appropriate this year to bring inflation down to 2% over time." IDFC First Bank sums it up aptly, “The Fed is trying to balance the risk of doing too much with doing too little, by slowing the pace of hikes, as it approaches peak policy rates."
The Fed’s softer policy tone is understandable. First, price pressures are easing. Headline CPI inflation in the US eased to a 27-month low of 3% y-o-y while core inflation also eased sharply in June.
Second, on the growth front, news is far from inspiring. The momentum in the US is softening across consumer spending, housing sector and business fixed investment. Even as labour markets remain tight, nominal wage growth has shown some signs of slowing down. Meanwhile, higher credit costs and tighter lending conditions will likely weigh further on economic activity and inflation. This strengthens the case for rate cuts going into 2024. Fed’s June dot plot projects 100 bps of rate cut by next year end, after the terminal rate likely peaking at 5.6% in 2023.
Back home, the Reserve Bank of India (RBI) is facing newer challenges. After a sizeable drop from March to May, inflationary pressures have started to firm up again, led by a broad-based increase in food prices. India’s CPI inflation inched higher to 4.8% y-o-y in June from a 25-month low of 4.3% in May. Agreed, a contained trajectory for core inflation (CPI excluding the volatile food and fuel components) has offered some breathing space to the central bank. But that may not be enough.
Uneven rainfall over the last few weeks has triggered concerns over the food inflation trajectory, particularly perishables. As a report by Nomura Global Markets Research points out, “While an anomalous spike in tomato prices (up over 200% m-o-m, in July) is the key reason, there are also broad-based price pressures across other vegetables (onions, potatoes), cereals, pulses and spices."
Adding to this, the potential risk of El Niño conditions could adversely impact global and domestic food supply and thus pose upward risks to inflation. As such, a sustained period of higher food prices may make households’ inflation expectations more entrenched and feed into demand side price pressures as well. This, if unchecked, may add to stubborn inflation conditions and make RBI’s job tougher. Thus, even as monetary policy may have little direct impact on supply-led food inflation, it is likely to add to RBI’s caution, keep the battle against inflation on and delay the rate easing cycle for India.
