US Fed signals rate hike next year to fight inflation. How soon will RBI follow suit?

The US Federal Reserve signalled Wednesday that it is out to firefight inflation, and quicken the pace of the withdrawal of the stimulus it had rolled out to boost the economy after the outbreak of Covid-19.

The Fed signalled that it is looking to begin raising interest rates as early as March next year. 

Why is the Fed looking to tighten credit right now?

Inflation in the US is at a four-decade high and wages are rising, while unemployment is coming down with hiring numbers are looking up. This, Fed chairman Jerome Powell thinks, is the right time to taper the stimulus and pull back.

This is why the policymakers at the Fed have signalled they are ready to tighten credit, beginning early next year. 

Has the Fed given any indication of how it plans to affect its rate hikes?

Yes, the Fed has said that it intends to hike interest rates three times next year. At present, its benchmark lending rate is near zero. 

How will a rate hike affect the common people and businesses?

A rate hike would mean that businesses and common people would have to pay higher interest rates on the loans they take. This will also mean that home, credit card and car loan rates will rise next year. On the flip side, savers will benefit as interest on fixed-income instruments such as bank deposits will increase, too.

Why is this policy announcement so surprising?

This policy announcement is surprising because as late as September, there was no unanimity among the Fed’s economists over the question of a rate hike. Now, the Fed appears intent on fighting inflation, rather than tackling the issue of unemployment. 

“We have to make policy now, and inflation is well above” the central bank’s 2% annual target, Powell said. “With elevated inflation pressures and a rapidly strengthening labor market, the economy no longer needs increasing amounts of policy support.”

In fact, the Fed had earlier said that inflation was “transitory” and had been caused mainly by supply-side bottlenecks in the wake of the coronavirus pandemic, which disrupted global business activity. But now, the Fed seems to acknowledge that inflation has persisted longer than it had earlier expected. 

“There’s a real risk now,” Powell said, “that inflation may be more persistent and that may be putting inflation expectations under pressure, and that the risk of higher inflation becoming entrenched has increased. I think part of the reason behind our move today is to put ourselves in a position to be able to deal with that risk.”

What is the Fed’s inflation forecast for the US?

Collectively, the Fed’s policymakers forecast Wednesday that inflation, as measured by their preferred gauge, will reach 5.3% by the year’s end. They expect inflation to slow considerably to a 2.6% annual rate by the end of 2022. But that’s still up from its September forecast of just 2.2%.

So, why should we in India be bothered?

Inflation has been a big concern even in India. Prices of all commodities have risen sharply over the past several quarters as the economy began to open up.

In its latest policy review earlier this month, the central bank maintained a status quo and kept rates constant for the ninth consecutive time. But going forward, this could change and rate hikes could be in the offing.

Indeed, now that the Fed has entered the firefighting mode, the Reserve Bank of India, too, could follow suit and begin raising repo rates.

Retail inflation rose to 4.9% in November from 4.5% in October, government data show. More worryingly, wholesale price inflation touched an all-time high of 14.2% in November.

No wonder, then, that many analysts are predicting rate hikes next year.

According to Sonal Varma, chief economist for India and Asia (excluding Japan) at Nomura, the RBI could increase its repo rate by 100 basis points cumulatively in 2022, up from its previous forecast of 75 basis points, due to higher inflation risks.