Powell's playbook

Fed is striving to maintain a fine balance

The Federal Open Market Committee (FOMC) of the US Federal Reserve, led by Chair Jerome Powell, made the right decision to increase the target range for the federal funds rate by 25 basis points on Wednesday. The rate-setting body was under significant pressure to pause, given the recent developments in the US banking system, which was partly the making of the central bank. The Fed, for quite some time, was of the view that inflationary pressures were transitory in nature and inflation would normalise with the normalisation of the economy after the pandemic-induced disruption. The delay in the policy response to inflation pushed the Fed to increase the policy rate at a faster pace. A sharp increase in interest rates, expectedly, resulted in accidents in the financial system, such as large losses for banks that had overwhelmingly invested in government bonds and mortgage-backed securities. The losses were too large for Silicon Valley Bank, for instance, to absorb.

It was thus argued that the Fed should not increase the interest rate and instead focus on preserving financial stability. Higher rates could increase stress in the system. However, a decision to pause at this stage could have indicated that the Fed was no longer in a position to act and contain inflationary pressures, which would have affected expectations and made its job even more difficult. The Fed, therefore, has tried to maintain a fine balance. Notably, Mr Powell in his recent remarks before the US Congress had noted that the eventual interest rate was likely to be higher than anticipated, which gave an impression that the FOMC would go for a 50-basis point rate increase in March. But the central bank has settled for a lower increase, partly because the tightening of credit conditions owing to stress in the banking system will affect demand and inflation outcomes the way higher interest rates would have.
 

The evolving situation has also changed the language of the FOMC statement, which suggests it may be close to the terminal rate. It is important to note the Fed, along with other regulators, is dealing with banking stress separately, as should be the case. Dependence on monetary policy to address financial stress could lead to bigger problems. The latest economic projections from the FOMC members suggest that the policy rate would go up by another 25 basis points this year, which is similar to the December projection. The majority of the members expect the core inflation rate to decline to 2.6 per cent in 2024, compared to 3.6 per cent in 2023, which is marginally higher than the December projections. The inflation outcomes and the related policy action, to an extent, would now also depend on stability in the financial system.

Although stress in the US and European banking systems has increased volatility in Indian financial markets, as things stand, it should not influence policy choices. The Monetary Policy Committee of the Reserve Bank of India, which will meet in the first week of April, would do well to focus on combating inflation. Headline inflation outcomes have surprised on the upside in recent months and core inflation continues to remain sticky. It is also worth noting that US-style stress in the Indian banking system is unlikely, partly because the extent of rate increases has been lower, and banks are more tightly regulated for such risks.