Shifting expectations

Markets are preparing for higher US interest rates

The battle against inflation is likely to last longer than most large central banks had anticipated. Statements and comments by Federal Reserve Chairman Jerome Powell in front of the Senate Banking Committee this week suggest that the US central bank may be preparing to increase the policy interest rate by another 50 basis points in the upcoming meeting of the Federal Open Market Committee on March 21-22, which means policy-induced volatility would continue in financial markets. The Fed had slowed the pace of rate hikes to 25 basis points after its last meeting on February 1, compared to 50 basis points in December 2022, and 75 basis points in the previous meetings. It has raised the federal funds rate to a range of 4.50-4.75 per cent, compared to near zero at the beginning of the cycle. The Fed’s December projections suggested that the federal funds rate would peak at 5.1 per cent in 2023.

However, it now appears that the underlying assumptions would need to be revisited. Large sections of the financial markets now expect the Fed to increase the federal funds rate by 50 basis points in March. Mr Powell in his remarks noted, given that recent economic outcomes were stronger than expected, the eventual level of the interest rate was likely to be higher than what was anticipated earlier. He further added that the Fed would be prepared to increase the pace of rate hikes if warranted. The unemployment rate in the US has declined to a 53-year low of 3.4 per cent. Economic activity clearly has been more resilient than what most economists expected. The International Monetary Fund in its January update of the World Economic Outlook, for instance, increased the 2023 growth projection for the US by 40 basis points compared to its September projection.
 

Interest rates higher than expected and lasting for long will have implications for financial markets. Both stocks and bonds fell after Mr Powell’s comments. The yield on two-year US government bonds went above 5 per cent. Global currency markets had stabilised somewhat as the Fed tapered the pace of its rate hikes. But volatility may again increase, which could put additional pressure on a number of developing economies with higher levels of foreign debt. It would also potentially increase pressure on the Indian rupee. After having sold Indian assets worth over $19 billion in 2022, foreign portfolio investors (FPIs) remain net sellers in 2023 so far. Although the current account deficit is likely to come down in the coming quarters, lower foreign direct investment flows along with selling by FPIs could lead to balance of payments pressures.

Besides, India is also facing sustained inflationary pressures. The inflation rate based on the consumer price index once again went above the upper end of the Reserve Bank of India’s tolerance band in January, and has increased policy uncertainty. It is possible that like in the US, the terminal policy rate in India would be higher than what was estimated earlier. Higher interest rates in the US, resulting in renewed pressure on the rupee, could also affect inflation outcomes. At a broader level, it would be important to see how the Fed approaches the situation from here on. With inflation at 6.4 per cent, it still has a long way to go in terms of attaining the medium-term target of 2 per cent.