The confusion of the world's central banks increased after the US banking crisis

- A serious threat to financial stability if global inflation is not controlled

Inflation based on the Consumer Price Index has once again remained above the upper end of the range set by the Reserve Bank of India. One of the reasons for this is the increase in prices of food grains and milk, among other things. Retail inflation stood at 6.44 percent in February, marginally lower than January's 6.52 percent. Thus, the headline inflation rate has been above 6 percent for 12 of the last 14 months. Considering these inflationary consequences, the Monetary Policy Committee will have to take a fresh look at its projections.

The committee had estimated that the average rate of inflation in the current quarter would be 5.7 percent, but that is now looking difficult. Improvements in the inflation outlook will also impact policy rate decisions. However, after what has happened recently in the US banking system, the rate decision will not necessarily be easy for the RBI or any other central bank. A sudden and sharp increase in interest rates by the US Federal Reserve was also partly responsible for the crisis because it significantly undervalued banks' investment portfolios, which consisted mainly of government bonds and mortgage-backed securities. According to one estimate, in December 2022, such holding companies incurred losses of over $600 billion. After the policy rate hike, it is also possible that the value of this portfolio may not be as much as it was in December. Valuations will fall further if the central bank raises rates to combat inflation.

The Federal Reserve has found a way to deal with the immediate problem but it is not permanent. The Federal Reserve lends to qualified institutions of the US Treasury and certain other institutions. This will help the financial institutions to overcome the immediate liquidity problem but will not solve the problem.

Financial markets are now watching the Federal Reserve to see if it will slow down in raising rates. Due to this reason, the bond market boomed. This was also partly done to hedge the risk. Last week the markets were sensing that the rate would rise sharply. This is because Fed Chairman Jerome Powell has said that interest rate levels may be higher than previously estimated.

The Fed's actual stance will be known on March 22, but volatility in the financial sector could create some confusion. Should it focus on fighting inflation or maintaining monetary stability? Most central banks, including the RBI, which have been raising rates, will face the same dilemma even though there is no immediate threat to financial stability.

This problem arose in part because most central banks were slow to respond to high inflation. Central banks should focus on controlling inflation because the risks of not doing so may be more serious. This can pose a serious threat to financial stability.

Immediate risk to the financial system can be mitigated by assessing potential losses to the portfolios of financial institutions and providing them with adequate capital. Central banks should be prepared for extended cash support. A continuous assessment of banks and other financial institutions in India will give the central bank an opportunity to achieve its price stability objective.