As the world faced the worst health crisis of the century, global central banks acted in concert, slashing interest rates to the lowest possible levels and infusing liquidity to support their economies. The normalisation of these easy money policies, which began last year, was also more or less in tandem, with all-pervasive inflation forcing the hands of central banks. But the monetary policies of the US Federal Reserve and the European Central Bank and the actions of the People’s Bank of China (PBOC) this week indicate that global central bank policies are going to diverge from this point, with each country deciding on its policy rate action based on the growth-inflation dynamics within the country.

While the US Federal Reserve maintained status quo, the ECB hiked its policy rate by 25 basis points while the PBOC has cut medium term lending facility and seven-day reverse repo rate by 10 basis points. This divergence could provide the Reserve Bank of India greater freedom to formulate its monetary policy based on the needs of the domestic economy. With the geopolitical tensions continuing, it is apparent that inflation is going to stay elevated for a longer period than previously expected. But the aggressive rate action to contain it is beginning to impact growth. While the Fed had indicated on earlier occasions that it was willing to sacrifice growth to contain inflation, there appears to be a shift in the Fed’s stance. The US central bank appears more concerned about the fallout of aggressive tightening as was evident in the Federal Reserve Chairman’s explanation for the pause, which he said was due to “the uncertain lags with which monetary policy affects the economy, and potential headwinds from credit tightening.”

That said, the Fed is certainly concerned that core PCE inflation, which excludes food and fuel, could turn troublesome and has therefore provided itself room to do two more 25 basis point hikes this year. The terminal Fed Funds rate, projected by Federal Reserve Board Members has been moved higher to 5.6 per cent from 5.1 per cent in the projections made in March 2023. The European Central Bank is however in a more difficult position with the inflation in the euro zone expected to be around 5.4 per cent in 2023. It therefore had to continue hiking rates despite growth getting hit. Bank of England, when it meets next week, may also be forced to hike its policy rate given that the inflation in UK is still above 8 per cent.

The Indian central bank will also have to be mindful about the impact of the 250 basis points rate hike on growth, particularly given the notable slowdown in private consumption. While it has paused the rate cycle for now, it can be open to the possibility of reducing interest rates, akin to China, once inflation trends lower on a sustained basis.

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