Rate Hikes – It is not just likely; now it is almost essential

For a long time, the discussion was about whether the central banks should hold rates or cut rates. A new narrative has been inserted in recent weeks; with a rate hike not only looking likely, but also quite essential.

What has changed in recent weeks?

To an extent, it all began with the US-Iran war in the Middle East. As Iran tried to dominate the narrative by blocking the Straits of Hormuz, the biggest casualty was world trade. For the Indian economy; which relied heavily on the Straits of Hormuz route for oil and gas, there was a sharp spike in the price of gas, crude oil, and oil intermediates. India may have kept inflation under check by holding petrol and diesel prices, but that may not sustain for too long. In the US, the consumer inflation has run up to 3.8% in April, a full 180 basis points above the Fed target of 2.0%.

It is something more than just inflation

Over the last one year, the US was struggling to decide which was the bigger risk; weak labour markets or higher inflation. Now, that debate has been set to rest. Despite all the geopolitical risks, the unemployment rate in the US is still at 4.3%. The GDP growth may have seen a marginal impact, but, overall, it still remains robust. With the rising prices of oil and gas, the big concern is inflation. It is not just about headline inflation. There is commodity inflation, there is inflation due to supply chain constraints and there is imported inflation. The real worry is that many of these supply chain constraints may not go away in a hurry, even if the geopolitical situation normalizes.

Rate hikes could be the answer to this challenge

Like in 2021 and 2022, this is once again a case of cost-push inflation. While a demand-pull inflation can be easily handled by hiking rates, the situation is slightly more complicated in case of cost-push inflation. Even in case of cost-push inflation, rate hikes do work, but they work with a lag. That means, rate hikes will have to start well in advance so that the impact on inflation can be seen after a time lag. Back in 2022, central banks made the mistake of waiting too long to hike rates. Having learnt that lesson, central banks are likely to be much quicker in hiking rates this time around. This applies to the Fed and also to RBI; and in both the cases, rate hikes could be imminent.

Why rate hikes are a necessity?

Be it the central bank of the US (Federal Reserve) or the central bank of India (RBI), there is a common expectation among people. The central bank is expected to anchor inflation expectations. The best way to anchor inflation expectations is by raising rates, even if the actual impact may only be visible after a time lag. Hence, the Fed and the RBI may not have much of a choice. They will have to start the process of hiking rates so that the credibility of the central bank is maintained. The extent of rate hikes would still be a matter of debate but the Fed and the RBI will have to give that signal to the market. It must show that the central bank is ready to anchor inflation expectations!