US Fed’s 75 bps rate hike: What monetary policy issues will RBI Gov Shaktikanta Das face now?

The Reserve Bank of India (RBI) Governor, Shaktikanta Das, will be more concerned as a result of the US Federal Reserve's decision to raise short-term rates by 75 basis points to 2.25 to 2.50 per cent.
 
This unanimous 75 basis points was almost priced in by the US market, but the strong commitment to bring down the inflation to 2 per cent sets the stage for more hikes in the near future, which will be a worry for emerging markets like India. The US Fed, which is way behind the curve, today said that they are highly attentive to inflation risks. Fed Chairman Jerome Powell said that they are also continuing with the process of significantly reducing the size of its balance sheet. 
 
The rising US interest rates present challenges for the RBI Governor as inflation in the domestic market is showing signs of receding. The new inflation trajectory calls for a 35 basis points hike in the repo rate in August policy to support the growth, but lowering of interest rate differentials between US and India, however, calls for a more aggressive 50 basis points hike to support the currency.
 
This is because the interest rate differential, which was around 3.75 per cent between US and India in the two pandemic years, has now shrunk to 2.40 per cent. This will discourage foreign portfolio investors to park funds in the Indian debt and equity markets.
 
CPI, or retail inflation, was 4.35 per cent in September last year but it increased sharply this year, reaching 6.95 per cent in March and 7.79 per cent in April. The CPI is beginning to decline as a result of a little easing in the price of commodities globally. In May, it dropped to 7.04 per cent and 7.01 per cent by June. The RBI Governor has publicly stated that inflation appears to have peaked. 
 
Currently, the headline and core inflation in India are much lower than the US and UK in terms of targeted inflation. India's central bank's inflation target is 4 per cent ( actual inflation at 7 per cent). In June, inflation reached 9.1 per cent, exceeding the target of 2 per cent. UK inflation has touched a 40-year high of 9.4 per cent. Given the low target of 2 per cent inflation, global central bankers will have to resort to more rate hikes to keep inflation under control.
 
Higher interest rates globally have already resulted in a flight of capital from emerging markets like India. This outflow of dollars is already strengthening the dollar value. A weakening rupee is actually creating a new headache for RBI as imported inflation is adding further fuel to the inflation fire.  
 
Jeffrey Halley, Senior Market Analyst, Asia Pacific, OANDA, a global financial services firm, believes that the RBI will use the opportunity to really push to get inflation below target. "Also, playing on their mind will be the weakness of the rupee, which doesn't give them any wriggle room to soften policy. As such, I expect the RBI to maintain firm monetary policy settings," says Halley.
 
The India-US yield differential is unlikely to change significantly, according to Arvind Chari, CIO of Quantum Advisors. 
 
The repo rate hike expectations are for 35 to 50 basis points in the August policy. "This would mean Indian short-term rates will rise, and thus, we do not expect any major changes in the India-US yield differential," says Chari.
 
Chari says India’s inflation and growth trajectory is very different from the one faced by developed economies. "The US, driven by the monetary and fiscal stimulus, is facing tight labour conditions and, over and above, the supply side disruption, is also seeing genuine demand and wage-driven inflation. So, in the US, you would see the Fed continue to hike and raise short-term interest rates," says Chari.

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