RBI and US Fed policies are more similar than you think

• The US Fed continues to play a leading role in setting the monetary policy tone for the rest of the world.
• While the RBI has maintained that its policies are tuned for Indian needs, it has mirrored US Fed’s rate policies more often than not.
• There have been a few instances of large divergence between RBI and US Fed’s policies – but those have typically been instances of radical economic events on a global scale.

The US Fed continues to set the tone for central banks around the world, and despite what the RBI says about its policies being independent and tailored for Indian needs, it has mirrored the US Fed more often than not.

One of the key tools that central banks have in managing economies is interest rate management. Interest rate policies allow central banks to manage the flow of money in the market, reducing or infusing liquidity as needed.

Hiking interest rates reduces the liquidity in the market and helps control inflation, while interest rate cuts infuse liquidity in the system and propel growth.

Central banks around the world have used interest rates as a tool to maintain a balance between growth and inflation, and when managed ineffectively – as we’ve seen in the case of Turkey – they can lead to an economic disaster.

A globalized economy means that most countries are impacted by economic events in the developed world, and the US Fed influencing monetary policies of other central banks is a prime example of this.

RBI has mirrored US Fed’s rate actions more often than not

The US Fed has hiked interest rates by 225 basis points in 2022 so far, while the RBI’s rate hikes amount to 90 basis points, with another 50 bps likely in the next few days.

This is despite the RBI saying its monetary policy is based on the global environment and tuned for the domestic circumstances. It also shows how the US Fed still leads the global monetary policy stance – all thanks to the global reserve currency status that the US Dollar enjoys.

To give a closer look into much the two central banks have diverged when, here’s how the difference in their rates has evolved over the past two decades.

Given that India is still a developing country and the Indian Rupee is less valuable than the US Dollar, the rates of inflation in India will be higher than in the US. This also means that interest rates in India tend to be higher than they are in the US.

Over the past two decades, the average divergence between the US Fed and RBI rates has been 367 basis points.

Given that inflation in developed countries like the US tends to be lower than in countries like India, interest rates also follow a similar pattern on most occasions. However, RBI and US Fed started moving in the opposite direction in 2006, when RBI continued to increase rates while the US Fed embarked on a rate cut regime which would last for over 9 years.

Eventually in late 2008, when India started feeling the boil of the financial crisis, RBI softened rates and reduced the gap between its rates and the US Fed’s.

The 2008 financial crisis triggered a steep rise in this divergence, with the US Fed slashing rates to almost 0% for several years. It was only towards the end of 2015 that the US Fed increased rates for the first time in nearly a decade, which is when the divergence between the Fed and RBI’s rates started declining.

Why are interest rates important?

Interest rates are one of the most powerful tools that central banks can wield – they control the economic fortunes of their respective countries, and that has a direct impact on your earnings.

A higher interest rate regime ostensibly means that the growth momentum has slowed down, so your wages will not rise as much as they did during the past two years.

On the other hand, this also controls inflation, which should help control your expenses.

How does this really matter to me?

A rise in interest rates in the US without a similar rise in rates in India makes India a less attractive destination for investment. This reduces the demand for Indian Rupee, which results in a further decline in its value.

A less valuable Rupee means our import bill increases, which results in prolonging inflation. At the end of the day, the common man is poorer.

This is why RBI has been using billions of dollars from its forex reserves to reduce the exchange rate volatility and keep the Rupee stable – experts say the RBI has done a good job of it so far, but the bill for its ‘Save the Rupee’ campaign has already cost $40 billion, and another $40 billion bill is still on the table.

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