Fed may talk less and let markets lead. That could spell more volatility for India

Much seems to be happening at US Fed under Kevin Warsh. As the most powerful central bank in the world, the entity that has the 'exorbitant privilege' of printing dollars, its actions are likely to have a ripple effect across global financial markets. It could also influence policy playbooks of other central banks, including RBI.

The core message Warsh wants to send is that Fed might not coddle the financial markets, particularly the bond markets, as much as it has done for the last few decades. Instead, traders and investors would have to rely more on their own reading of the future of the economy and set prices and interest rates accordingly.

Also Read| Fed says too little, RBI is too predictable. Both may have a problem


The formal way of coddling the markets is through forward guidance, a road map of how the central bank sees the economy behaving in the future, and what its likely response would be. A key element of this is the famous 'dot plot', a visual summary of forecasts for inflation and interest rate changes made by the 12 members of Federal Open Market Committee (FOMC), which meets eight times a year to set the benchmark policy interest rate. Warsh wants to do away with the dot plot and reduce the frequency of the meetings.

Remember, interest rates form the bedrock of all prices of all financial instruments. The stock IPO you invest in, EMIs or the rupee's exchange rate at which you remit your money abroad all depend on interest rates. Global financial markets are interlinked, and Fed's interest rate movements quickly transmit to Indian markets. Federal funds rate (FFR) is the world's benchmark interest rate.

Warsh's plan to let markets lead, instead of follow, Fed might just be, if his critics are right, a way of getting out of the rock and hard place he finds himself in. As a Trump appointee, he can't entirely displease the White House, which is hell-bent on getting interest rates down.

On the other hand, as boss of an independent central bank, he can't ignore inflation pressures emanating from a likely increase in inflation driven by energy prices that the US war on Iran has pushed up, coupled with solid demand-pull inflation from a massive investment upswing in AI-related infrastructure.

Letting markets decide might just be a clever way to let bond markets drive bond yields and the effective interest rate up. This might well be Warsh's version of an 'off-ramp' - getting interest rates up, fighting inflation pressures, without touching the policy rate.

This has its problems. The absence of forward guidance to anchor market expectations could lead to more aggressive movements in yields than warranted as markets react to headline macroeconomic news, particularly inflation. Central bank reticence is also likely to increase volatility in bond markets that will spill over to other markets like currencies and stocks.

The biggest fear the market has is that a less-garrulous Fed would also obfuscate its 'reaction function', or the rule implicit in the dot plot, and the Fed statement of how it would respond to outturns in macroeconomic variables. A reaction function is a rule that might read somewhat like: 'If inflation remains elevated and unemployment continues to be muted, tighter monetary policy [Fed-speak for policy rate increase] is warranted.'

To be fair, removing forward guidance does not necessarily mean that Fed won't reveal its reaction function. But until Fed does so, investors and traders are likely to remain edgy.

Central banks have reason to fret over this. If Fed decides to follow, rather than lead, the market in determining interest rates, central banks over the world will have to focus more on the mood of the markets than on the FOMC meeting calendar.

This is particularly important when it comes to managing the exchange rate. A higher-than-expected inflation release could lead to a far sharper rise in key US bond yields than in a Fed-led monetary regime, inducing dollar outflows and faster rupee depreciation. Stock and commodity markets also follow cues from the Fed, and with this shift in regime, they are likely to remain jumpy, at least for a while, until Fed's modus operandi becomes clearer.

However, the bigger worry might stem from Warsh's pet peeve - Fed's bloated balance sheet, or 'base money', that ultimately determines the number of dollars sloshing around in the financial system. This, Warsh argues, makes the central bank too big a player in financial markets, and restricts its ability to print emergency dollars in times of crisis. If, indeed, Fed were to trim its balance sheet aggressively, it could result in capital outflows from emerging markets like India.

Long story short, two things need to be borne in mind. Monetary policy in an economy like India, or indeed any other economy, cannot decouple from the US. If that is true, RBI needs to brace itself for fundamental shifts in Fed's approach and paradigm.

RBI might, among other things, want to think of becoming nimbler in its policy-setting, cutting short its policy calendar, and keeping the powder dry to tackle swings in global markets quickly.