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Context: The Federal Reserve of the United States (Fed) announced a hawkish pause. The Fed's hawkish pause was motivated by several factors, such as the uncertainty caused by the trade war with China, the slowdown in global growth, the volatility in financial markets, and the partial government shutdown. The Reserve Bank of India (RBI) also adopted a hawkish pause in February 2023, after raising its repo rate three times in 2022.

Details

Hawkish pause

• A hawkish pause is a term used to describe a situation where a central bank decides to keep its policy rate unchanged after a series of rate hikes but signals that it is still ready to raise rates further if needed.
• It implies that the central bank is not satisfied with the current level of inflation and wants to keep a tight grip on monetary policy.
• It is different from a dovish pause, where a central bank also keeps its policy rate unchanged, but indicates that it is unlikely to raise rates in the near future. A dovish pause suggests that the central bank is more concerned about supporting growth and employment than containing inflation.

Why did the Fed and the RBI adopt a hawkish pause?

• The Fed and the RBI have both been raising interest rates since 2022 to prevent inflation from rising above their target levels. The Fed has a 2% inflation target, while the RBI has a 4% target with a tolerance band of +/- 2%.
• Both central banks faced some challenges in their tightening cycles. The Fed had to deal with the uncertainty caused by the regional banking crisis and its impact on global growth and financial stability.
  • The RBI had to cope with the volatility in oil prices and the exchange rate, which affected domestic inflation and growth.
• Both central banks decided to pause raising interest rates to assess the situation and allow the economy to adjust to higher borrowing costs. However, they also made it clear that they were not done with tightening and that they would act again if inflation pressures persisted or intensified.

What are the implications of a hawkish pause?

• A hawkish pause has important implications for both the domestic and the global economy and financial markets.

For the domestic economy

• A hawkish pause means that monetary policy remains restrictive and that borrowing costs remain high for households, businesses and the government. This could dampen consumer spending, investment and fiscal stimulus, and slow down economic growth. On the other hand, a hawkish pause could also help anchor inflation expectations and prevent inflation from spiralling out of control.

For the global economy

• A hawkish pause by the Fed and the RBI could have spillover effects on other countries, especially emerging markets.
• A hawkish pause by the Fed could strengthen the US dollar and put pressure on other currencies, especially those with large current account deficits or external debt.
• A hawkish pause by the RBI could reduce capital inflows and increase capital outflows from India, affecting its balance of payments and foreign exchange reserves.

For financial markets

• A hawkish pause could create volatility and uncertainty, as investors adjust their expectations and portfolios.
• It could trigger a sell-off in bonds, as bond yields rise to reflect higher interest rates.
• It could weigh on stock prices, as higher borrowing costs reduce corporate earnings and valuations.
• It could affect commodity prices, as higher interest rates reduce demand for commodities and increase supply from producers.

How do investors react to a hawkish pause?

• A hawkish pause is not necessarily bad for all investors. Some investors could benefit from a hawkish pause by taking advantage of higher interest rates or currency movements. For example, investors who hold cash or short-term bonds could earn higher returns from a hawkish pause.
• Investors who have exposure to US dollar-denominated assets or exporters could gain from a stronger US dollar.
• Investors who have exposure to sectors those are less sensitive to interest rates or inflation, such as technology or healthcare, could outperform those that are more sensitive, such as utilities or real estate.

The significances of a hawkish pause are:

• It signals that the central bank is confident about the strength and resilience of the economy and its ability to withstand higher interest rates.
• It shows that the central bank is vigilant and proactive in fighting inflation and maintaining price stability.
• It provides some relief and breathing room for borrowers, businesses, and financial markets that may be struggling with higher borrowing costs and tighter credit conditions.
• It creates some uncertainty and ambiguity about the future path of monetary policy, which may increase market volatility and speculation.

Effects of a hawkish pause are:

• It may have a mixed impact on economic growth, depending on how consumers, businesses, and investors react to the pause and the expectations for future rate hikes.
• It may have a positive impact on inflation, as it signals that the central bank is committed to keeping inflation under control and within its target range.
• It may have a negative impact on financial stability, as it may trigger capital outflows, currency depreciation, and asset price corrections in emerging markets and other countries that are vulnerable to higher US interest rates.
• It may have a positive impact on market confidence, as it demonstrates that the central bank is transparent, credible, and responsive to changing economic conditions

Challenges of a hawkish pause are:

• It may be difficult to communicate and justify a hawkish pause to the public and the markets, especially if there is a discrepancy between the central bank's projections and market expectations.
• It may be challenging to calibrate and implement a hawkish pause in a dynamic and complex economic environment, where new data and developments may warrant a change in policy stance.
• It may be risky to adopt a hawkish pause in a situation where inflation is high and persistent, as it may undermine the central bank's credibility and effectiveness in anchoring inflation expectations.
• It may be costly to reverse a hawkish pause if the economy weakens or faces a negative shock, as it may require more aggressive rate cuts or other policy measures to stimulate growth and restore stability.

The US Fed's Hawkish Pause: Implications for India

• The US Federal Reserve has recently announced a pause in its rate hike cycle, after raising the policy rate 10 times since 2022. This decision came as a surprise to many market participants, who expected the Fed to continue tightening its monetary policy to combat rising inflation. This hawkish pause has implications for the Indian economy and markets, which are closely linked to the US financial system.

Effect on the Rupee

• One of the main effects of the Fed's pause is that it reduces the pressure on the Indian rupee, which has been depreciating against the US dollar due to the widening interest rate differential between the two countries.
• A weaker rupee makes imports more expensive and fuels inflation in India, which is already above the Reserve Bank of India's (RBI) target range of 2-6%.
• A stable rupee also helps attract foreign portfolio investors, who have been net sellers of Indian equities and debt in recent months.

Effect on Borrowing Costs

• Another effect of the Fed's pause is that it lowers the borrowing costs for Indian corporates and households, that depend on external sources of funding.
• A higher US policy rate increases the risk premium for emerging market debt, making it more difficult and costly for Indian entities to raise funds abroad.
• A lower US policy rate also reduces the debt servicing burden for Indian borrowers, who have to repay their loans in US dollars.

Risks and Challenges

• The Fed's decision reflects its concern about the slowing US economy, which could have spillover effects on global growth and trade.
• The US is India's largest trading partner, accounting for about 16% of India's exports and 8% of its imports.
• A slowdown in the US demand could hurt India's export-oriented sectors, such as IT services, pharmaceuticals and textiles.
• The Fed's pause does not mean that it has abandoned its inflation-fighting stance. The Fed could resume its rate hike cycle sooner than expected if inflation persists or accelerates in the US. This could again create volatility and uncertainty in the global financial markets, and pose challenges for India's macroeconomic stability.

Policy Recommendations

• India needs to be prepared for both scenarios: a prolonged pause or a sudden reversal of the Fed's policy stance.
• The RBI should maintain its flexible inflation-targeting framework, and adjust its policy rate according to the evolving domestic and external conditions.
• The RBI should continue to use its foreign exchange reserves to intervene in the currency market, if needed, to prevent excessive volatility or misalignment of the rupee.
• The government should pursue fiscal consolidation and structural reforms, to enhance India's growth potential and resilience to external shocks.

Conclusion

• A hawkish pause is not a permanent state of affairs. It is a temporary pause that could be followed by either a resumption of rate hikes or a reversal of rate hikes, depending on the economic conditions and the inflation outlook.

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PRACTICE QUESTION Q. What does hawkish pause mean in the context of monetary policy? A) A temporary halt in raising interest rates by a central bank that is usually inclined to do so B) A permanent stop in lowering interest rates by a central bank that is usually inclined to do so C) A temporary halt in lowering interest rates by a central bank that is usually inclined to do so D) A permanent stop in raising interest rates by a central bank that is usually inclined to do so Answer: A Explanation: A hawkish pause is when a central bank that normally favours higher interest rates to control inflation decides to pause its rate hikes for a while to assess the economic situation and avoid causing a recession. Q. What is the possible effect of a hawkish pause on the exchange rate of a currency? A) It will appreciate as investors expect higher interest rates in the future B) It will depreciate as investors expect lower interest rates in the future C) It will appreciate as investors perceive the currency as more stable and attractive D) It will depreciate as investors perceive the currency as riskier and more volatile Answer: C Explanation: A hawkish pause may strengthen the exchange rate of a currency, as it implies that the central bank is confident about the economic outlook and ready to resume its rate hikes if needed. This makes the currency more appealing to investors who seek higher returns and lower risks.

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