Indian stock markets, along with stock markets around the globe, have responded to news about US inflation going up. Expectations of further rate cuts and injection of liquidity into money markets have been dampened after the news on inflation. Central banks face their most difficult times when economies are faced with both a slowdown in growth and a rise in inflation. In the last one decade, especially after 9/11, the job of central bankers was easy. With economic growth continuing to be robust, it was easy for central banks to focus on inflation control. In fact, inflation rates and GDP volatility were both kept low by inflation-targeting central banks. The US Fed, albeit not legally wedded to inflation targeting, has effectively been an inflation targeting central bank since the chairmanship of Paul Volker. Now, this easy phase of central banking has come to an end with the subprime crisis.
Should central banks now go soft on the inflation target and worry more about staving off an impending slowdown by cutting rates? The current Fed Chairman Ben Bernanke?s earlier statements had indicated that the American central bank was now concerned about a recession, raising market expectations of rate cuts till the danger was averted. Then, the US Fed, ECB and Bank of England all acted in concert to pump liquidity into the system. However, the recent news on inflation has scared markets again, and, as Monday?s market mayhem showed, few expect the Fed to ignore rising prices. The betting is that the US Fed is now likely to go slow on cutting rates. For India, this may be good news. In any case, the RBI needs to cut domestic interest rates to reduce pressure on the rupee. Sharp cuts in interest rates in the US would have widened the interest differentials with the US even further. High differentials create an incentive for capital to flow into India. With the rupee already on a sharp upward incline, the RBI would have had to cut interest rates even more sharply. Even though the WPI has been benign over the last few weeks, the fact that oil prices might need to be revised sets up inflationary pressure points that cannot be ignored. The RBI will still have to cut rates in India, but may not have to do so that aggressively.
