Why Fed’s big hike is great for India


The US Federal Reserve has firmed up its inflation-busting credentials with another quarter percentage-point increase in interest rates this week, and has left the door open for more hikes and spikes. The policy rate is now 5.25-5.50% – a range last seen just before the 2007 housing market crash – and headed upward with slowing inflation still running twice as high as the 2% target as unemployment remains low at 3.6%.

The US economy is surprisingly resilient, posting growth with a revival of services. The Fed is not convinced that the terminal interest rate can be fixed yet. This, despite the most rapid monetary tightening in four decades.

Monetary policy is not conforming to the copybook after decades of almost free credit in advanced economies. This could have a spillover on export-oriented emerging economies, whose growth is pegged on that of the US and EU.

A shallower-than-anticipated slowdown in the world economy will require interest rates to stay high for longer in order to bring inflation under control. By avoiding widespread trade destruction, the world may find it easier to work with higher credit costs. International capital flows will also be less disruptive as interest rates remain elevated but stable. Exchange rates, likewise, will be less volatile with lower demands on foreign exchange reserves to prop up currencies.

India gains on all these counts. It can expect a revival of exports that have come off last year’s scorching pace. Capital flows are strengthening after an initial flight. The rupee is not under undue pressure. And the country is rebuilding its foreign exchange reserves. Barring a fresh shock, RBI has little reason to raise its policy rate beyond the current level of 6.5%. This makes the India-US interest rate differential a mere percentage point. This should have had a profound effect on capital flows. However, India’s growth outperformance is offsetting some of it. This will be modulated if the external environment improves.



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