Coming Soon: End of rate hike

The US Federal Reserve raised interest rates by 75 basis points on Wednesday for the fourth time in a row to 3.75-4%. Comments by chair Jerome Powell following the decision turned attention to the terminal rate rather than future pace of increases. Powell's statement that the final interest rate will be higher than previously expected is in accompaniment to the rate-setting committee's assessment that future hikes will be guided by the effect of monetary tightening accomplished this year. Projections for the peak interest rate have moved up to 5% from 4.6% after the Fed's September policy action. Interest rates tend to decelerate as they approach the summit, which allows previous monetary adjustments to produce their intended results. The US economy is beginning to experience pockets of slowdown, as in the housing market, but the job market tightness persists.

The final federal funds rate and its duration will have a bearing on the terminal interest rate for RBI in terms of capital flows and exchange rate movements. On current indications, RBI is likely to reach its peak rate with a lag to the Fed, and the eventual interest rate differential is expected to be narrower than historic levels. This last bit owes more to exceptionally low US interest rates since the global financial crisis and RBI will have to actively defend the rupee even after steady states are reached in policy rates. India may have to reconcile itself to a slower build-up of forex reserves, particularly if its economic growth momentum stalls.

The Fed has pretty much discounted the possibility of overshooting, and this raises the prospects of a recession in the US. RBI, on its part, has to deliver on persistent core inflation consumption demand recovery.