Source: FRED database

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Source: FRED database

High inflation in the United States means trouble for countries all over the world, including India. Typically, central banks try to control inflation by raising interest rates. The Federal Open Market Committee (FOMC) of the Federal Reserve of the United States, the American central bank, is scheduled to meet on 15 and 16 March. The FOMC decides on the interest rate policy of the Federal Reserve.

It is widely expected that the FOMC will raise interest rates. In fact, Jerome Powell, the chairman of the US Fed, told the US House of Representatives earlier this month, that he was “inclined to propose and support a 25-basis-point rate hike”. One basis point is one-hundredth of a percentage.

As can be seen from the chart, the retail inflation in the US has been way off the charts for close to 11 months now, starting in March 2021, when it was at 2.7%. Over the years the Fed has tried to set interest rates with the aim of maintaining inflation at 2%.

Of course, the supply chain disruptions due to the spread of the covid pandemic were responsible for the start of this inflation. And now the high price of oil is feeding into it. Two things that the Fed doesn’t have control over.

Nonetheless, high inflation, whatever may be the reason behind it, feeds into people’s expectations of high future inflation. As Gavin Jackson writes in Money in One Lesson: “The simplest way of predicting what inflation [will] be tomorrow [is] to look at what it [is] today and so higher prices [will] be incorporated into these expectations.” Given this, high inflation ultimately finds its way into wages, leading to a wage spiral, which is currently happening in the United States.

In this scenario, the Fed in order to maintain its credibility as an inflation fighter, needs to be seen to be doing something. This means that the FOMC is most likely to raise interest rates when it meets to discourage consumption and hope to control inflation. After this meeting, the FOMC is scheduled to meet six times during 2022. It is widely expected that the FOMC will raise interest rates in four to five of these meetings.

As the US Fed raises interest rates, it could mean a major headache for the Reserve Bank of India (RBI) and India. In the last couple of years, in the aftermath of the negative economic impact of the covid pandemic, the Fed and other central banks of the rich world have created printed money and driven down interest rates. The idea was to encourage people and companies to borrow and spend money and in the process help the economy. Take the case of home prices in the US which have been rising at greater than 18% per year since June 2021, primarily due to rock bottom home loan interest rates. Higher interest rates can help control this.

Lower interest rates in the rich world sent investors looking for returns in stock markets all over the world, including India. This explains the rapid rise in stock prices since April 2020. Nonetheless, with interest rates expected to go up in the United States, foreign institutional investors have gradually been selling Indian stocks.

In 2022, foreign institutional investors have sold stocks worth 1.1 trillion. Also, with the Fed widely expected to raise interest rates, the selling is gradually spreading to debt securities as well. In March, foreign investors have sold debt securities worth 4,205 crore.

This selling will only accelerate when the Fed raises interest rates.

When foreign investors sell Indian stocks or debt securities, they get paid in rupees. They need to convert these rupees into dollars. This increases the demand for the dollar, leading to the dollar appreciating against the rupee. In other words, the rupee depreciates.

At the end of February, one dollar was worth 75. By 8 March, it was at 77.1. At the time of writing this, the dollar was worth 76.6.

A depreciating rupee increases the price of imports, including oil, coal, edible oil, fertilizers, metals and natural gas, much of which India imports. This will feed into retail inflation and inflationary expectations.

The RBI can stem the fall of a falling rupee by selling dollars from the foreign exchange hoard that it has built up. Nonetheless, it needs to be careful doing this, simply because, unlike rupees, the RBI cannot create dollars out of thin air.

The other thing it can do is raise interest rates to encourage foreign investors to get dollars and invest in India. Of course, this would mean first getting out of the accommodative stance on which it has remained stuck for a while.

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