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High inflation in the United States means trouble for countries around the world, including India. Typically, central banks try to control inflation by raising interest rates. The Federal Open Market Committee (FOMC) of the United States Federal Reserve, the US central bank, is scheduled to meet on March 15 and 16. The FOMC decides on the Federal Reserve’s interest rate policy.
It is widely expected that the FOMC will raise interest rates. In fact, US Fed Chairman Jerome Powell told the US House of Representatives earlier this month, that he was “willing to propose and support a 25-basis-point rate hike”. A basis point is one hundredth. One percent.
As can be seen from the chart, retail inflation in the US has been off the charts for almost 11 months starting March 2021, when it stood at 2.7%. Over the years the Fed has attempted to set interest rates with the aim of keeping inflation at 2%.
Of course, supply chain disruptions due to the spread of the COVID pandemic were responsible for the onset of this inflation. And now the high oil price is feeding it. Two things that the Fed doesn’t have control over.
Nevertheless, high inflation, whatever the reason behind it, meets people’s expectations of higher inflation in the future. As Gavin Jackson writes in Money in One Lesson: “The simplest way to predict inflation” [will] tomorrow comes [is] to see what it is [is] Today and so much higher prices [will] These expectations must be included.” Given this, high inflation eventually finds its way into wages, leading to the wage spiral, which is currently occurring in the United States.
In this scenario, the Fed needs to be seen doing something to maintain its credibility as an inflation fighter. This means the FOMC is likely to raise interest rates in hopes of discouraging consumption and controlling inflation. After this meeting, the FOMC is scheduled to meet six times during 2022. It is widely expected that the FOMC will raise interest rates in four to five of these meetings.
As the US Fed raises interest rates, it could mean a huge headache for the Reserve Bank of India (RBI).reserve Bank of India) and India. Over the past few years, following the negative economic impact of the COVID pandemic, the Fed and other central banks in the wealthy world have printed money and lowered interest rates. The idea was to encourage people and companies to borrow and spend money and help the economy in the process. Take the case of home prices in the US, which have been growing at over 18% per annum since June 2021, mainly on account of rock bottom home loan interest rates. Higher interest rates can help control this.
Low interest rates in the wealthy world sent investors looking for returns in stock markets around the world, including India. This explains the rapid increase in stock prices since April 2020. Nevertheless, with interest rates expected to rise in the United States, foreign institutional investors are gradually selling off Indian stocks.
Foreign institutional investors have sold shares of 1.1 trillion. In addition, with the Fed widely expected to raise interest rates, sales are gradually spreading to debt securities as well. Foreign investors sold debt securities of value in March 4,205 crores.
This sale will only accelerate if the Fed raises interest rates.
When foreign investors sell Indian stocks or debt securities, they get paid in Rs. They need to convert these rupees into dollars. This increases the demand for the dollar, which in turn strengthens the dollar against the rupee. In other words, there is devaluation of Rs.
At the end of February, one dollar was worth 75. By March 8, it was on 77.1 The dollar value at the time of writing this was 76.6.
A depreciating rupee pushes up the price of imports, including oil, coal, edible oil, fertilisers, metals and natural gas, most of which India imports. This would include retail inflation and inflation expectations.
RBI can stop the fall of the falling rupee by selling dollars from the forex reserves maintained by it. However, caution is needed in doing so, simply because, unlike the rupee, the RBI cannot make dollars out of thin air.
The second thing it can do is raise interest rates to encourage foreign investors to get dollars and invest in India. Of course, this would mean first breaking out of the liberal stance on which it has been stuck for some time.
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