Will Fed now head towards a pause?

The US Federal Reserve may have reached its terminal level of its current interest-rate upcycle. The differential with the Indian policy rate is 1.25 percentage points, less than a third of what it was a little over a year ago. The Fed could have gone further with rate hikes. It is, however, pausing prematurely as pockets of stress in the US banking industry continue a disorderly credit squeeze. The extraordinarily slim policy-rate gap can be expected to throttle debt and equity flows as interest rates stay elevated till inflation approaches target. The Reserve Bank of India (RBI) has set the inflation glide path to reach 4% in 2024-25. An unusually tight labour market and vulnerable banks do not offer similar clarity on inflation timelines to the Fed.

The severity of a US recession will affect India's balance of payments (BoP), as will the pace of China's recovery from Covid lockdowns. This should be offset by cooling commodity prices, even though oil-producing nations may manage to enforce a price floor for crude. Remittances are diversified across advanced and emerging economies, which is likely to help them maintain their secular trend. The rupee will, however, face pressure on both the current and capital accounts till the interest rate differential with the US regains its historical levels.

This supports India's efforts to improve export competitiveness in manufacturing. Managed currency depreciation can augment import substitution and export incentives. Fragmenting trade has, on its part, improved market access for Indian petroleum products while rerouting investments in electronic supply chains. India has positioned itself for a bigger role in the new trading order, and continuing global dislocations appear to be favouring it. As globalisation ebbs in manufacturing, it enters a new phase in services that is less affected by the pandemic and the geopolitics of the Russia-Ukraine war and beyond. Financial market turbulence should push Indian policymakers to shore up the country's position.