High inflation in the United States means problems for countries around the world, including India. Generally, central banks try to control inflation by raising interest rates. The Federal Open Market Committee (FOMC) of the US Federal Reserve, the US central bank, is due to meet on March 15-16. The FOMC decides the interest rate policy of the Federal Reserve.
The FOMC is widely expected to raise interest rates. In fact, Jerome Powell, the chairman of the US Fed, told the US House of Representatives earlier this month that he was “inclined to propose and support a 25 basis point rate hike.” A basis point is one hundredth of a percentage.
As the chart shows, US retail inflation has been off the charts for almost 11 months now, starting in March 2021 when it was 2.7%. Over the years, the Fed has attempted to set interest rates with the goal of keeping inflation at 2%.
Of course, supply chain disruptions due to the spread of the covid pandemic were responsible for the start of this inflation. And now the high price of oil is fueling it. Two things the Fed has no control over.
Nevertheless, high inflation, for whatever reason, fuels people’s expectations of high future inflation. As Gavin Jackson writes in Money in One Lesson: “The easiest way to predict what inflation will be [will] to be tomorrow [is] look what it is [is] today and therefore higher prices [will] be incorporated into these expectations. Given this, high inflation eventually trickles down to wages, leading to a wage spiral, which is happening in the United States right now.
In this scenario, the Fed, in order to maintain its credibility as an inflation fighter, must be seen to be doing something. This means the FOMC is more likely to raise interest rates when it meets to discourage consumption and hopefully control inflation. After this meeting, the FOMC is expected to meet six times in 2022. It is widely expected that the FOMC will raise interest rates at four to five of these meetings.
As the US Fed raises interest rates, it could mean a major headache for the Reserve Bank of India (RBI) and India. Over the past two years, following the negative economic impact of the covid pandemic, the Fed and other central banks in the rich world have created printed money and lowered interest rates. The idea was to encourage individuals and businesses to borrow and spend money and, in doing so, help the economy. Take the case of house prices in the United States, which have been increasing by more than 18% per year since June 2021, mainly due to the lowest mortgage interest rates. Higher interest rates can help control this.
Falling interest rates across the wealthy world have prompted investors to seek returns in stock markets around the world, including India. This explains the rapid rise in stock prices since April 2020. Nevertheless, with interest rates expected to rise in the United States, foreign institutional investors have gradually sold Indian stocks.
In 2022, foreign institutional investors sold shares worth ₹1.1 trillion. Additionally, with the Fed widely expected to raise interest rates, the selloff is also gradually spreading to debt securities. In March, foreign investors sold debt securities worth ₹4,205 crores.
This sell off will only accelerate when the Fed raises interest rates.
When foreign investors sell Indian shares or debt securities, they are paid in rupees. They have to convert these rupees into dollars. This increases the demand for the dollar, causing the dollar to appreciate against the rupee. In other words, the rupee depreciates.
At the end of February, a dollar was worth ₹75. On March 8, it was at ₹77.1. At the time of this writing, the dollar was worth ₹76.6.
A depreciating rupee raises the price of imports, including petroleum, coal, edible oil, fertilizers, metals and natural gas, much of which is imported by India. This will fuel retail price inflation and inflationary expectations.
The RBI can stem the fall of a falling rupee by selling dollars from the currency hoard it has accumulated. Nevertheless, he must be careful while doing this, simply because, unlike rupees, RBI cannot create dollars out of thin air.
The other thing it can do is raise interest rates to encourage foreign investors to get dollars and invest in India. Of course, that would first mean getting out of the dovish attitude he’s been stuck on for some time.
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