In his first speech in two months on the outlook for the US economy, Federal Reserve chairman Ben Bernanke has signalled that the US central bank is now more worried about inflation and that rate cuts are on hold. He also said that he’s concerned about the sharp drop in the value of the dollar, which has added to inflationary pressures in the US by making imports more expensive. The impact on the market has been immediate: Fed fund futures now show a negligible probability of a rate cut at the Fed’s next meeting on 25 June and the dollar has strengthened. The markets had been increasingly coming around to the view that the US Fed had done with cutting rates after the minutes of the last Fed meeting showed the central bank was very worried about inflation, and Bernanke’s speech is a confirmation of that position.
Illustration: Jayachandran / Mint
The change of stance has several implications. It has already started taking some of the sheen off commodities, including oil, because commodities are viewed as a hedge against a falling dollar. Dollar rallies are, therefore, accompanied by lower commodity prices. That should have a salutary effect on inflation, not just in the US but across the globe. True, the balance of supply and demand in commodities will undoubtedly continue to be a potent factor, especially so far as oil prices are concerned, but at least the dollar effect on prices will be less. A stronger euro will also help the European economy, which has been groaning under the weight of its appreciating currency. On the negative side, the boost to US exports and corporate earnings that has been provided by a weaker currency may fade. Also, it is by no means certain that merely holding interest rates will be enough to provide a sustainable boost to the dollar and reduce inflation. Interest rates may, in fact, have to be raised to achieve that objective, which will have negative implications for housing markets in the US and for consumer demand. The Fed’s change of stance is, in fact, an acknowledgment of the difficult choices it faces.
India will of course be one of the chief beneficiaries if oil prices cool off. The rupee may get a boost from a lower oil import bill and the fiscal deficit may not widen as much as expected earlier. Unfortunately, however, the Indian government remains behind the curve in raising fuel prices and that will have a much greater impact on inflation than any change in the US interest rate outlook.
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