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India must prepare as US Fed shifts stance

If the balance sheet of the US Federal Reserve represented an economy, it would be the world’s third largest at $7.9 trillion. Any prospective change in the size of its balance sheet or its interest rates influences financial markets across the world, forcing other central bankers to adjust their policy stance. This week the Federal Reserve’s board indicated that it may raise interest rates by late 2023 and look at shrinking its balance sheet to adjust to changing economic conditions. It was enough to rattle financial markets.

Widespread vaccination and huge fiscal support have charged up the US economy. Driven by consumer spending, the annualised growth of the world’s largest economy this year is expected to be a robust 6.4%. Simultaneously, inflation has soared to 5% in May, way above the Federal Reserve’s target of 2%. Therefore, as financial markets second guess when the current loose monetary policy will be reversed, there will be bouts of volatility. This will affect almost everyone as foreign portfolio investments get reallocated according to changes in US interest rate. Global financial market volatility is now a given.

Within this larger context, RBI and GoI face another challenge. The pace of India’s economic recovery has slowed after the second wave. The current policy challenge is to keep interest rates low to support growth even as consumer inflation has begun to trend upwards to 6.3% in May. Financial market volatility can squeeze space for both monetary and fiscal policy. Both RBI and GoI need to prepare for a scenario where the Indian economy will need continued monetary support and additional fiscal packages to revive domestic consumption even when financial markets are volatile. It’s best to work out the details of fiscal support early as the best antidote to a volatile phase is to provide certainty to all stakeholders.



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This piece appeared as an editorial opinion in the print edition of The Times of India.



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