What Does the Fed Signaling Caution Mean for India?

Contrary to analysts’ expectations of a dovish tone, the US Federal Reserve’s commentary on June 12 was far from benign. The Fed indicated a reluctance to implement significant interest rate cuts as the fight against inflation persists.

Despite easing inflation in the US, Federal Reserve officials now foresee only one quarter-point cut in policy rates by the end of 2024, a notable shift from the earlier projection of three rate cuts as per the March median estimate. This adjustment disappointed some in the financial markets, which had anticipated two cuts this year from the current target range of 5.25-5.5 percent for the federal funds rate.

Implications of the Fed’s Stance

The median estimate for the Fed-funds rate target range at the end of 2025 has increased by a quarter percentage point, from 4 percent to 4.25 percent, implying a cumulative reduction of one percentage point next year.

What This Means for India

The Reserve Bank of India (RBI) will consider signals from major central banks like the Fed when making rate decisions. While the Fed’s plans for a rate cut this year could influence the RBI’s Monetary Policy Committee (MPC), domestic factors will primarily drive the RBI’s actions.

During last week’s monetary policy press conference, RBI officials emphasized that while they monitor the Fed, their rate decisions will be primarily based on domestic economic conditions rather than external influences.

Historically, the RBI has often aligned its actions with cues from the Federal Reserve. However, the RBI has its own inflation targeting goals. The Indian central bank expects inflation to average 4.5 percent in fiscal 2025, with quarterly estimates of 4.9 percent for Q1, 3.8 percent for Q2, 4.6 percent for Q3, and 4.5 percent for Q4.

In May, consumer price index-based inflation cooled to 4.75 percent, slightly down from 4.83 percent in April. Core inflation, which excludes volatile items, also eased to below 3 percent. Nonetheless, the medium-term target of 4 percent remains elusive. The RBI will need to reassess its interest rate policy in the second half of the fiscal year, considering the inflation trend. Ideally, the window for rate cuts may open only next year, based on the RBI’s projections.

Positive Growth Outlook

Fortunately, the growth momentum remains steady, which is a relief for the RBI. With growth projected at 7.2 percent for FY25, the RBI has some flexibility. A weaker growth scenario would have pressured the central bank to support the economy with early rate cuts.

Key Risks Ahead for the RBI

1. Monsoon Performance: Poor monsoon distribution could impact crop production and supply, posing an upside risk to food inflation. As food inflation remains a concern, the monsoon is a critical factor to monitor.
2. Populist Fiscal Policy: The recent election results, which forced the ruling BJP to form a coalition government with the Congress-led opposition emerging as a strong rival, could lead to compromises on fiscal policy. If the government adopts a populist budget under pressure from allies, it could complicate inflation management, potentially requiring the MPC to maintain higher rates for longer.
3. Geopolitics and Commodity Prices: An escalation in the Israel-Iran conflict could drive up global crude oil prices, and a possible heatwave across India could spike food inflation, disrupting the RBI’s inflation strategy.

While the Fed’s rate decisions are influential, the RBI’s actions will likely be more dependent on domestic factors.

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