Opinion US Fed’s decision to raise interest rates underlines that central banks cannot afford to ignore inflationary concerns

Saugata Bhattacharya writes: Uncertainty over financial stability persists. But resilience of the Indian banking sector is reassuring

A display shows Fed chairman Jerome Powell's news conference while traders work on the floor at the New York Stock Exchange. (Photo: AP)

Saugata Bhattacharya

March 25, 2023 09:09 AM IST First published on: Mar 23, 2023 at 03:44 PM IST

The US Federal Reserve chose, without dissent, to raise its policy rate by 0.25 percentage points (ppt), following the decision by the European Central Bank to hike its rate by 0.5 ppt. These decisions show that central banks cannot yet afford to take their eyes off inflation, even though the banking environment and the effects on the broader economy are clouded with uncertainty.

There has, however, been a material change in the communication and guidance of the two central banks. The Fed has clearly indicated that “tighter credit conditions for households and business” are likely to “weigh on economic activity, hiring and inflation”. In other words, uncertainty about the banking sector has partially done the Fed’s job, affording them the option of smaller rate hikes and a lower peak rate. This is a significant change from the market’s perception of a very hawkish stance by Fed chairman Jerome Powell in his testimony to the US Congress just about a month back. While the median forecast of the terminal rate by the Fed’s policy committee remains the same, a change in the language of the policy statement signals a big shift. The phrase “ongoing increases” in interest rates (a staple of many past policy statements) was replaced by the intent to “closely monitor incoming information” to decide policy action. The committee had actually considered a pause in rate hikes at the meeting.

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The risk of another “financial accident” has probably receded due to the response of the central banks, regulators and governments. Powell noted that SVB’s failure was largely due to concentrated deposits and a bet on long duration bonds on the asset side. The value of these bonds dropped sharply when interest rates rose quickly. These conditions cannot be generalised to the broader US banking system. However, chairman Powell surmised that the effect of tighter credit conditions was the equivalent of a 0.25 ppt rate hike.

The ECB, too, has broadly indicated that with fears of a contagion receding, controlling high inflation remains their unwavering target. Yet, they have not given any forward guidance on future rate hikes, unlike in the previous few meetings, and have instead become “data dependent”.

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The global economy, if anything, has become even more uncertain. The speed and magnitude of policy rate hikes and borrowing costs are very likely to cut into discretionary spending, slow demand and the momentum of economic activity. How this plays out though is uncertain. Economic conditions in large developed geographies still remain quite robust, the US even more so. The non-housing services sector, in particular, remains strong. The Fed’s economic projections, despite tighter credit conditions, remain virtually unchanged compared to December 2022. The inflation forecast is up.

Central banks now face a difficult balancing act. The effects of uncertainty in the banking sector on economic activity are “potentially quite real”, but remain unclear. Yet they are clearly separating the use of specific policy instruments to target different objectives, which is what economic theory would suggest. The objective of cooling inflation is thought to be best achieved through the transmission of higher interest rates to borrowers, while various liquidity and credit support measures are being used to stabilise banking sector fragility. The Fed’s “dotplot” still retains the end-2023 median policy rate of 5-5.25 per cent, but more members now project a higher rate.

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How will all this affect India, both in terms of the growth momentum and the policy response? Will this affect the monetary policy committee’s rate decision at their next meeting in April? The RBI recently assessed that the economy remains resilient with “a steady gathering of momentum since the second quarter” of 2022-23. This is supported by high-frequency economic indicators which, while moderating, remain strong. As in the developed markets, the services sector remains particularly strong. Core inflation still remains uncomfortably persistent, with 57 per cent of the components of core inflation still above 6 per cent. Yet anecdotal evidence and conversations are beginning to suggest a slowing down in certain segments, particularly affordable housing and automobile dealerships.

On the other hand, RBI data shows India’s banking sector — in fact, the financial system — remains sound. Banks have stable, largely deposit-based funding, ample liquidity, little or no exposure to start-ups, and asset books have large high-quality liquid assets. As of September 2022-23, scheduled commercial banks were highly capitalised and asset stress was low. The capital adequacy ratios of urban co-operative banks and NBFCs remain high.

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Hence, a 0.25 ppt hike in the repo rate is still probably the likely outcome, although, like the Fed, there is bound to be discussion on whether this is an opportune moment to pause. A smaller, non-conventional increase also remains a possibility. It will be a difficult decision. One benefit of G10 central banks approaching their peak rates is that depreciation pressures on the rupee are likely to moderate. The guidance of policy is also likely to change, with MPC unlikely to retain the stance “focused on removal of accommodation”. It is likely to become more flexible and data-dependent. Other than rate actions, RBI’s management of system liquidity, which is likely to become structurally neutral, or even in deficit, sometime in 2023-24, will also play a role in guiding market interest rates and hence the cost of funds for borrowers.

The lessons from the latest episodes of global volatility are that financial sector shocks, during a transition from easy monetary and fiscal policies, can emanate from relatively unexpected sources. Points of weakness at individual institutions are bound to persist; they will remain vulnerable to external developments. The RBI’s stringent regulatory oversight mechanisms and the ongoing monitoring of banking stability frameworks will now provide it with greater operational flexibility in its monetary policy response. These should become a template for other banking regulators.

The writer is Executive Vice President and Chief Economist, Axis Bank. Views are personal