The US Federal Reserve Board's Federal Open Market Committee (FOMC), in its scheduled meeting last week, unanimously agreed to a change in its policy guidance. The word "patience" - which had been interpreted by analysts to reflect an indefinite commitment to the zero interest rate policy - was dropped. This is being seen as an indication that the first rate increase is just around the corner, perhaps as early as June. Of course, other than this change in terminology, the FOMC statement maintains that the current stance is appropriate for the prevailing macroeconomic conditions, with inflation well below the tolerance limit of two per cent.
The main reason for a build-up in market expectations about an impending increase in the federal funds rate is the positive news on the unemployment rate, which is steadily approaching what may be seen as a floor rate of five per cent. However, since the inflation rate is still well below the limit, there is still some cushion available to the Fed, which it may use to justify a longer stretch for its current stance. Significantly, the average of the inflation forecasts of the FOMC members has it below one per cent during 2015 and only approaching the two per cent mark in 2017. The combination of soft commodity prices and a strong dollar is evidently helping to neutralise the inflationary impact of falling unemployment and its corollary, rising capacity utilisation.
In any event, whether in June or sometime after, given the current trajectory of the US economy, a sequence of rate increases is inevitable and the rest of the world must anticipate and prepare for its impacts. The strongest manifestation of these will undoubtedly be on capital flows and, through these, on currencies. India has had to deal with two major bouts of turbulence directly flowing from developments in the United States. The first was in 2011, precipitated by a downgrade in the sovereign rating of the United States, while the second was in 2013, when fears about the Fed rolling back its massive liquidity infusions first materialised. However, the situation has changed dramatically as far as India's vulnerability is concerned.
Measures taken by the government and the Reserve Bank of India (RBI) in response to the 2013 upheavals and the sharp decline in commodity prices over the past several months have helped to considerably narrow the current account deficit, taking it into a relatively safe zone of below two per cent of gross domestic product (GDP). In the meanwhile, capital inflows have increased, reversing the downward pressure on the rupee. Against this backdrop, the confidence in India's relative immunity from actions taken by the Fed expressed by Governor Raghuram Rajan recently is justifiable. However, while this view may be valid in the short run, policymakers must not overlook potential risks on the balance of payments front over the medium term. One manifestation of these is the sharp decline in exports last month, which could be attributed to the significant real appreciation of the rupee over the past year. Another risk factor is the prospect of oil prices rising sharply as global capacity rebalances in response to the current price scenario. India's perennial vulnerability on the external front requires continuous vigilance and proactivity. The current favourable conditions must not be allowed to induce complacency.
