Fed & all the rest financial market volatility will remain interest rates should not be used as all purpose blunt instrument

Fed & all the rest financial market volatility will remain interest rates should not be used as all purpose blunt instrument

Global financial markets yesterday experienced sharp volatility following US Federal Reserve chairman Jerome Powell’s take on inflation last week. He said that restoring price stability will take time and Fed would need to use its tools forcefully. His remarks were interpreted to mean interest rate hikes may go on longer than expected. That, in turn, will undermine economic growth to a relatively greater degree. India too felt the impact. The rupee-dollar exchange rate breached the Rs 80 mark before closing marginally above it, and BSE Sensex dipped by 1.5% to settle just below 58,000.

The global economy is in an odd phase. The US has entered recession territory with output shrinking over two successive quarters and business manager surveys for Europe and Japan are flashing red. Yet, hiring continues, triggering the term “jobful recession”. India too is in an unusual phase. Inflation is forecast by RBI to average 6.7% in 2022-23, breaching the 6% threshold for the second time in three years. Aggregate demand, however, has been weak. Overheating is not the primary problem here.

Since May, RBI’s monetary policy committee has increased the repo rate by 1.4 percentage points to 5.4% to check second-round effects of inflation. Even though the rate of inflation slowed in the last couple of months, risk of trend reversal remains. Oil prices are again rising and the Indian barrel of crude was $99.6/barrel on August 26. Also, the rainfall pattern may impact food grain prices. On August 26, the acreages of paddy and pulses were lower by 6% and 5% respectively. On the positive side, FIIs’ net inflows surged to almost $7 billion in August after being negative the first six months.

Financial market volatility will persist. In this context, RBI and GoI need to be careful about deploying their tools. Inflation in India is still mainly driven by supply constraints. Interest rates shouldn’t be used to combat anything but inflation as it slows economic momentum. Dealing with this tricky phase requires using the panoply of monetary and fiscal instruments, not just interest rates.