The rate hike blast will spare no one

Photo: Bloomberg
Photo: Bloomberg


A US Fed caught behind the curve on price stability poses major risks for emerging markets as well

One of the quirks of American English is that “momentarily" means in a moment, rather than for a short time. Last year, the US Federal Reserve’s repeated use of “transitory" in its discussion of inflationary pressures on the US economy, ranging from shortages of semiconductor chips to bottlenecked supplies because US ports had too few workers and shipping lines too few containers, perhaps also created some linguistic confusion. In December, US inflation rose a staggering 7%, a four-decade high, with even core inflation (excluding fuel and food) up 5.5%.

Late last year, Fed chair Jerome Powell promised to stop using the term transitory. It was an admission that the Fed had been looking at inflation through metaverse-tinted glasses. In the real world, companies were passing on higher prices for their inputs and labour. Economists such as Lawrence Summers warned that the combination of a third massive stimulus in the US and the massive infusion of liquidity by the Fed would propel inflation to levels the US had not seen in decades. The drop in stock markets last week was because Powell has now made clear that he will not be constrained by gradualism in raising interest rates as his predecessors Alan Greenspan and Janet Yellen were. The market is expecting as many as—gasp—seven rate hikes this year and even a 0.5% increase in one stroke.

This has implications for India and other developing countries because the US rate is a pivotal benchmark. But, it also matters because India has sticky inflation while being held hostage to a global rise in fuel and food prices. The heavy increase in capital expenditure by the government on highways, railways and urban infrastructure laid out in Tuesday’s budget may or may not adequately revive the hitherto weak investment by the private sector, but it immediately prompted bond yields to jump to 6.85% because government borrowings will rise. Interest payments now constitute almost a quarter of government expenditure and are in effect crowding out spending on food subsidies, healthcare and education. (The multiplier effects of better highways notwithstanding, imagine managing a household budget this way.) This was made worse by there being no announcements of changes that would ease the way for India’s inclusion in global bond indices. As Ananth Narayan of the Observatory Group notes, “Higher-than-expected central and state fiscal deficits and the absence of any tax changes to facilitate inclusion of India’s debt into global bond indices have spooked domestic bond markets."

All is not quiet on the western or eastern trade fronts either. Supply-chain distortions continue to push prices up globally for everything from factory supplies to Swiss watches. Last week, the White House warned that US factories had only five days of inventory for important chips versus a typical 40-day buffer. A Long Story in Mint on Tuesday observed that in January mustard oil prices were 67% higher than in 2020, while milk was up by 15%. Vegetable prices in recent months have been volatile. Like the Fed, the Reserve Bank of India’s acquiescence on interest rates suggested that it believed inflation was “transitory". Perhaps it was making up for the absence of a meaningful fiscal stimulus.

Indeed, against a backdrop of labour participation rates among the lowest in the world, New Delhi’s reduction in outlays for make-work programmes and its calculation that the urban poor do not need help during a pandemic that has hit them disproportionately continues to baffle. Our high vaccination rate, now at above 75% of the country’s adult population, is an immense achievement that India should be cashing in on.

To pick just one example: Tourism accounted for 10% of global employment pre-pandemic, but our restrictions on visas for foreign travellers and week-long quarantines for visitors from overseas who manage to get here are an example of policy framed by looking in the rear-view mirror.

Omicron, as the experience of South Africa had telegraphed several weeks ago, turned out to be just a bout of the flu for most of us. When the governments of Karnataka and Delhi announced weekend lockdowns in early January in response to rising cases of covid infection, I asked a restaurant manager in Bengaluru what his last two years had been like. “We have been broken," he poignantly replied, his face creased with worry.

By contrast, the Biden administration at least set out to run the US economy red-hot in a bid to lift incomes of low-paid workers, a New Deal for the 21st century. The Fed’s mistake was to let interest rates remain well below the US inflation rate for so long. Now inflationary expectations have hardened, and tamping prices down is like slowing a pinball machine. It is not just semiconductors and steaks that cost more in America; prices are rising more than 2% for more than two-thirds of the price indicators used to calculate inflation. William Dudley, a former New York Fed president, predicts that US short-term rates could reach 3% or 4% in the coming years. Fed officials have often suggested that rates may eventually settle at around 0.5% in real terms. But, as Wall Street Journal columnist Greg Ip warned last week, “It’s been a long time since markets had to grapple with a Fed behind the curve. It’s a recipe for unpleasant surprises, more market volatility and a risk premium in the form of higher bond yields or lower stock-market valuations."

As US interest rates rise, rise and rise, the pain borne by America, India and others is likely to be the very opposite of transitory.

Rahul Jacob is a Mint columnist and a former Financial Times foreign correspondent.

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