To the point

The Fed has made its policy position clear

US Federal Reserve Chairman Jerome Powell spoke for about nine minutes in his much-anticipated appearance at the Jackson Hole economic policy symposium on Friday, but it was sufficient to send a clear message. Financial markets tumbled and the widely tracked S&P 500 cracked by over 3.3 per cent. With some early signs of relatively low inflation, partly because of a decline in commodity prices, markets had started believing that the Fed would not tighten policy to the extent anticipated earlier. One of Mr Powell’s recent statements was also interpreted in the same vein. But this time he was more direct and clearly underlined that restoring price stability would take time and the Fed would use its tools “forcefully to bring demand and supply into better balance”.

This would undoubtedly impose a cost on the economy in the short run. Renewed clarity in the Fed’s stance warrants adjustments in global financial markets.
 

The inflation rate in the US declined from 9.1 per cent in June to just 8.5 per cent in July and remains significantly above the Fed’s target of 2 per cent. The most critical question for financial markets thus is to what extent the Fed will increase interest rates, and by when. It pushed up the policy rate by 75 basis points each in the last two meetings and it is possible that the next meeting in September would also lead to a similar outcome before the pace of rate hikes is slowed. Sustained hikes will tighten global financial conditions and affect capital flows to an emerging market country like India. It is worth noting that other large central banks in advanced economies are also expected to tighten.
 

The European Central Bank (ECB) is expected to increase the policy rate by 50 basis points in September. Aside from the state of the economy, the ECB will also have to keep an eye on the potential impact on sovereign debt in the region. Hedge funds are reportedly betting heavily against Italian debt. The Bank of England, meanwhile, could also face significant challenges. According to one estimate, the inflation rate in the UK is expected to rise to 18 per cent by early next year. Monetary policy action in advanced economies would clearly increase growth risks for the global economy in the near to medium term. A weaker global economy with tighter financial conditions would affect an emerging market country like India in multiple ways. While exports would be affected because of weak global demand, capital inflows will remain under pressure due to risk aversion. This could affect India’s external position if commodity prices, particularly those of crude oil, remain elevated.
 

It was reported last week that Indian sovereign bonds are being considered for inclusion in a global index, which could result in a potentially stable inflow of about $30 billion. While the inflow would impart greater stability to the currency and reduce the cost of borrowing for the government, policymakers would need to handle this with extreme caution. It should not be allowed to re-enforce the systemic bias for a stronger currency, which could create longer-term imbalances. Overall, the global situation, partly because of geo-political reasons, would not be supportive in the foreseeable future, and would affect economic outcomes in India. Policy calculations and market expectations must be adjusted to this underlying reality.