Ahead of US Fed decision, RBI is latest central bank to take rate action

High inflation has forced several central banks to increase policy rates but there has been a pick-up in rate action in recent days ahead of a likely rate hike announcement by the world's most important central bank.

The Indian central bank raising the rate is not a surprise—many economists expected it to do so at its June meeting. But the outside-the-meeting-calendar nature of it has certainly grabbed attention.

The RBI rate hike is also the latest in a series of monetary policy tightening actions by central banks around the world in recent days.

On May 3, the Central Bank of Colombia increased its benchmark interest rate by a massive 100 basis points to 6 percent. The same day, the Reserve Bank of Australia undertook the first rate hike in a decade, raising the cash rate target by 25 basis points to 0.35 percent.

Last week, Sweden's Riksbank increased its repo rate by 25 basis points to 0.25 percent, its first rate hike since the coronavirus pandemic began. Hungary's Magyar Nemzeti Bank raised the central bank base rate by 100 basis points to 5.4 percent.

Other central banks to raise their policy rate in the last couple of weeks include those of Botswana, Paraguay, and Kazakhstan.

While high inflation due to rising energy prices, among other factors, has forced the hand of central banks, they have also acted in anticipation of similar moves by Big Daddy the US Federal Reserve.

The US central bank's Federal Open Market Committee began its two-day meeting on May 3. The committee's decision is due later on May 4, where it is widely expected to increase the federal funds rate target range.

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According to the CME Group's FedWatch Tool, there is a 97.9 percent probability the Fed will raise the federal funds rate target range by 50 basis points on May 4 to 0.75-1 percent. And the tightening of financial conditions in the US—which itself is facing the highest inflation in several decades—is sending ripples across the world.

"The prospect of an accelerated increase to US interest rates and the impact on international prices of Russia's invasion of Ukraine could lead to additional inflationary pressures," the Central Bank of Colombia said on May 3. Hungary's central bank said expectations of a Federal Reserve rate hike was driving risk appetite.

As far as India is concerned, RBI governor Shaktikanta Das' statement and the Monetary Policy Committee's (MPC) resolution may not have namechecked the Federal Reserve but there was certainly a reference to it.

The MPC said in its resolution that "volatility spillovers from monetary policy normalisation in advanced economies" was a risk to domestic economic activity.

Das was more forthright. "Further, the normalisation of monetary policy in major advanced economies is now expected to gain pace significantly—both in terms of rate increases and unwinding of quantitative easing as well as the rollout of quantitative tightening. These developments would have ominous implications for emerging economies, including India," the governor warned.

In mid-to-late 2013, Indian monetary policy was actually driven by the Fed's actions. First came the taper tantrum that began nine years ago this month. Then came a series of rate actions to cauterise the wound caused by the massive capital outflows from India. And in what was an explicit nod to the Indian central bank's focus on what its US counterpart was doing, former RBI governor Raghuram Rajan postponed his first interest rate decision by two days to have "enough time to consider all major developments in the required detail".

The Indian economy may now be in a far stronger position than it was in 2013 to counter foreign policy spillovers but one cannot deny US monetary policy continues to play a role in shaping some of our, and others', moves.