US Fed will keep rates steady amid high inflation: Why this matters for the global economy

Inflation “still too high”

According to data released by the US Labour Department’s Bureau of Labour Statistics on April 10, the consumer price index in the US increased by 0.4 per cent month-on-month and surged 3.5 per cent year-on-year, overshooting Wall Street expectations.

US Fed Chair Jerome Powell said Monday inflation was “still too high” and rate cuts would not be on the cards until he had “greater confidence” that price growth was inching down towards its 2 per cent target. “It is likely that gaining such greater confidence will take longer than previously expected,” Powell told a press briefing after the conclusion of the two-day policy meeting.

“We are prepared to maintain the current target federal funds rate for as long as appropriate… Inflation is still too high, further progress in bringing it down is not assured, and the path forward is uncertain,” he said. Powell added the rate cuts going forward would “depend on the data”.

“If we did have a path where inflation proves more persistent than expected, and where the labour market remains strong but inflation is moving sideways and we’re not gaining greater confidence, well, that would be a case in which it could be appropriate to hold off on rate cuts,” he said.

In response to a query on future rate action, Powell even went on to say this: “I think it’s unlikely that the next policy rate move will be a hike”. The delayed guidance on future rate cuts, alongside the mention of the word hike, seems to have curbed market enthusiasm further, which had rallied in the run up to the closely-watched announcement, before ending mostly down as investors soaked up the fineprint.

The S&P 500 had jumped over 1.1 per cent in afternoon trade May 1, before closing 0.3 per cent, while London’s FTSE 100 inched down 0.3 per cent after the Fed presser, according to Reuters data. This is despite the fact that the European Central Bank officials are sticking to a forecast of multiple interest rate cuts this year, the indications of the US Fed going slower with its rate cut plans notwithstanding.

Why are these signals from the US Fed important?

Like other central banks such as the RBI, as the US Fed conducts monetary policy, it influences employment and inflation primarily by using policy tools to control the availability and cost of credit in the economy. The Fed’s primary tool of monetary policy is the federal funds rate, changes in which influence other interest rates — which in turn influence borrowing costs for households and businesses, as well as broader financial conditions.

When interest rates go down in an economy, it becomes cheaper to borrow; so households are more inclined to buy more goods and services, and businesses have an incentive to borrow funds to expand operations, buy equipment or to invest in new projects.

Improved demand for goods and services ends up pushing up wages, and helps rekindle the growth cycle. Even though the linkages of monetary policy to inflation and employment are not direct or immediate, monetary policy is a key factor in curbing runaway prices or stoking the growth impetus.

Theoretically, a signal to cut policy rates in the US should be a positive for emerging market economies, especially from a debt market perspective. Emerging economies such as India tend to have higher inflation and, therefore, higher interest rates than in developed countries.

As a result, investors, including Foreign Portfolio Investors, tend to borrow in the US at lower interest rates in dollar terms, and invest that money in the bonds of countries such as India in rupee terms to earn a higher rate of interest.

What will be the impact on other markets, including India?

A cut in rates in the US could have a three-pronged impact. When the Fed cuts its policy rates, the difference between the interest rates of the two countries could widen, thus making countries such as India more attractive for the currency carry trade. The lower the rate in the US, the higher the arbitrage opportunity, till the time that the rate cut cycle starts in other economies as well.

A lower rate signal by the Fed would also mean a higher impetus to growth in the US, which could be yet positive news for global growth, especially when China is reeling under the impact of a real estate crisis and showing signs of slowing down. Lower returns in the US debt markets could also trigger a churn in emerging market equities, improving foreign investor enthusiasm. There is also a potential impact on currency markets, stemming from inflows of funds.

For the RBI, like other central banks, the likelihood of a future rate cut is somewhat predicated on the US Fed’s decision to cut rates.

On April 5, the six-member Monetary Policy Committee of the RBI had kept the repo rate – the rate at which India’s central bank lends money to banks to meet their short-term funding needs – unchanged for the seventh consecutive time at 6.5 per cent, while indicating the possibility of retail inflation coming below the crucial level of four per cent in the second quarter (July-September) of FY 2025.

This has raised expectations of a rate cut later this year, but in all probability that could happen only after the US Fed cuts its benchmark rates.

The RBI last cut the repo rate by 40 basis points to 4 per cent in May 2020 when the Covid pandemic raged across the country affecting the entire economy, leading to slowdown in demand, production cuts and job losses. Since then, the RBI has hiked the repo rate by 250 points to 6.5 per cent in order to tackle runaway inflation.

It has projected an inflation of 4.9 per cent in Q1, 3.8 per cent in Q2, 4.6 per cent in Q3 and 4.5 per cent in Q4 of FY’25. The central bank has a mandate to keep inflation at 4 per cent, with a cushion of 2 per cent on either side.