US Federal Reserve, India's RBI, And An Attempt To De-couple The Markets From The West

While in matters of monetary policy, the RBI is guided by the domestic economic growth-inflation conditions and their outlook, monetary policy in advanced economies does impact markets, the Governor said in his policy statement.

Markets are wondering if the RBI is preparing ground for a rate cut ahead of the US Fed. Or is the RBI making way to tame inflation with much more vigour by keeping interest rates at the current levels, even if the US Fed goes ahead with the rate cuts, most likely by the year end.

“With GDP growth revised upwards and inflation under control, is there a need to reduce interest rates even if Fed reduces its rates in near future? Or should we not reduce interest rates and further increase our growth even if Fed plays the wait-and-watch game? In either case, our economy is on strong footing for sustainable economic growth," said Siddarth Bhamre, Head of Research, Asit C. Mehta Investment Intermediates.

To inform, measures by either of the central banks on interest rates can alter the rate differential between the two countries, thus influencing foreign capital flows into or outside India. If the RBI cuts the rate ahead of the US Fed, the rate differential narrows, thus risking outflows as Indian assets start fetching lower returns. On the other hand, if RBI stays put while US Fed cuts rate, Indian assets will attract inflows.

‘Follow The Fed’

Using Cricket parlance, the Governor in his policy statement on Friday said, "There is a view that in matters of monetary policy, the Reserve Bank is guided by the principle of ‘follow the Fed’. I would like to unambiguously state that while we do keep a watch on whether clouds are building up or clearing out in the distant horizon, we play the game according to the local weather and pitch conditions.”

The Governor was citing a 2022 IMF working paper by Huertas, Gonzalo titled “Why Follow the Fed? Monetary Policy in Times of U.S. Tightening.” Whether most central banks react to US Fed decisions either for controlling inflation or preventing capital outflows has been debated extensively in this paper.

"We interpret this ('follow the Fed’ comment) to mean that even if the Fed easing cycle gets pushed out because of US growth-inflation dynamics, the RBI can ease if inflation in India eases by Q4 (December-March). On the other hand, if inflation in India stays sticky, the RBI is unlikely to ease even if a Fed easing cycle is underway," said Goldman Sachs in a note on June 7.

An Attempt To De-Couple

Indian markets see such reiterations by the RBI as an attempt to significantly decouple India's monetary policy from that of the advanced economies. The aim seems to be to protect domestic markets from excessive volatility.

To highlight, because of growth issues central banks from advanced economies like Switzerland, Sweden, Canada and the Euro Area have already begun their rate easing cycle in 2024. This is despite status quo by the US Fed. Recently, the European Central Bank announced interest rate cut by 25 basis point for the first time in nearly five years, moving ahead of the US Fed and Bank of England. Will India follow suit or stay put?

"An asynchronous global monetary policy cycle (first-rate cuts from the ECB and the BOC, while the Fed holds on) will encourage the RBI to be in a wait-and-watch mode. The chance of a rate-cut cycle starting with the October policy will be high if the global growth metrics, especially in the US, deteriorate faster than expected, in addition to a Fed rate-cut cycle starting in July/September," said Kotak Bank in a report post the policy announcement. The bank expects a shallow rate cut cycle (75-100 basis points) from the December policy onwards, with the policy stance changing either in October policy or along with the rate action.

In Conclusion

It’s worth noting that today no analysis of India's monetary policy gets complete without mentioning the US Fed in the same breath. Clearly, despite what the RBI wants the market to believe, no researcher is betting on a rate cut in India ahead of the US Fed.

Research firm PhillipCapital expects the RBI to cut the repo rate by 25-50 basis points in the December-March quarter of the ongoing fiscal year. But this is assuming that the US Fed delivers rate cuts before that. "Considering RBI’s hawkish and persisting stance on inflation targeting, rate cut in fiscal year 2024-25 seems unlikely until inflation cools off ahead of expectations...In case of marginal changes in the Fed rates, RBI would stay on a prolonged pause in the fiscal year 2024-25, assuming inflation trends remain above 4%," it said in a note.

The ongoing fiscal year will be the fourth consecutive year with economic growth at or above 7 per cent. Many believe that it’s difficult to maintain such momentum without monetary policy easing. At the same time, even a long-term rally in the stock markets can fizzle out if the inflation stays higher. India needs to chart out its own policy path. But this must happen without much disruption.

Foreign portfolio investment (FPI) flows in India surged in 2023-24 with net inflows at US$ 41.6 billion. However, since the beginning of 2024-25, FPIs have turned net sellers in the domestic market with net outflows of US$ 5.0 billion (till June 5). Much of this could be due to uncertainty on lowering rates by the US Fed.

"In our view, India’s foreign exchange (FX) reserves at $650 billion-plus will continue to allow the RBI to insulate FX transmission channel from US monetary policy cycle into domestic monetary policy," noted Goldman Sachs in a note.

To further drive home the point of independence in policy matters, the Governor added in his live broadcast on Friday, “I have said this several times earlier, but it becomes necessary to restate the position and reiterate this, so that there is clarity in the mind of market participants and other stakeholders, and as a result of which they do not board the wrong bus."

Governor’s comment about ‘follow the Fed,’ is construed by the market as a strong push-back against mechanically following the US Fed to predict India’s monetary policy.