Representational image of the seal of the Board of Governors of the United States Federal Reserve System
| Photo Credit: AP

United States Federal Reserve officials will likely make official what’s been clear for many weeks: With inflation sticking at a level above their 2% target, they are downgrading their outlook for interest rate cuts.

In a set of quarterly economic forecasts they will issue after their latest meeting ends, the policymakers are expected to project that they will cut their benchmark rate just once or twice by year’s end, rather than the three times they had envisioned in March.

The Fed’s rate policies typically have a significant impact on the costs of mortgages, auto loans, credit card rates and other forms of consumer and business borrowing. The downgrade in their outlook for rate cuts would mean that such borrowing costs would likely stay higher for longer, a disappointment for potential homebuyers and others.

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Still, the Fed’s quarterly projections of future interest rate cuts are by no means fixed in time. The policymakers frequently revise their plans for rate cuts — or hikes — depending on how economic growth and inflation measures evolve over time.

But if borrowing costs remain high in the coming months, they could also have consequences for the presidential race. Though the unemployment rate is a low 4%, hiring is robust and consumers continue to spend, voters have taken a generally sour view of the economy under President Joe Biden. In large part, that’s because prices remain much higher than they were before the pandemic struck. High borrowing rates impose a further financial burden.

The Fed’s updated economic forecasts, which it will issue Wednesday afternoon, will likely be influenced by the government’s May inflation data being released in the morning. The inflation report is expected to show that consumer prices excluding volatile food and energy costs — so-called core inflation — rose 0.3% from April to May. That would be the same as in the previous month and higher than Fed officials would prefer to see.

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Overall inflation, held down by falling gas prices, is thought to have edged up just 0.1%. Measured from a year earlier, consumer prices are projected to have risen 3.4% in May, the same as in April.

Inflation had fallen steadily in the second half of last year, raising hopes that the Fed could achieve a “soft landing,” whereby it would manage to conquer inflation through rate hikes without causing a recession. Such an outcome is difficult and rare.

But inflation came in unexpectedly high in the first three months of this year, delaying hoped-for Fed rate cuts and potentially imperiling a soft landing.

In early May, Chair Jerome Powell said the central bank needed more confidence that inflation was returning to its target before it would reduce its benchmark rate. Powell noted that it would likely take more time to gain that confidence than Fed officials had previously thought.

Last month, Christopher Waller, an influential member of the Fed’s Board of Governors, said he needed to see “several more months of good inflation data” before he would consider supporting rate cuts. Though Mr. Waller didn’t spell out what would constitute good data, economists think it would have to be core inflation of 0.2% or less each month.

Mr. Powell and other Fed policymakers have also said that as long as the economy stays healthy, they see no need to cut rates soon.

“Fed officials have clearly signaled that they are in a wait-and-see mode with respect to the timing and magnitude of rate cuts,” Matthew Luzzetti, chief U.S. economist at Deutsche Bank, said in a note to clients.

The Fed’s approach to its rate policies relies heavily on the latest turn in economic data. In the past, the central bank would have put more weight on where it envisioned inflation and economic growth in the coming months.

Yet now, “they don’t have any confidence in their ability to forecast inflation,” said Nathan Sheets, chief global economist at Citi and a former top economist at the Fed.

“No one,” Mr. Sheets said, “has been successful at forecasting inflation” for the past three to four years.

File photo: A Reserve Bank of India (RBI) logo is seen inside its headquarters in Mumbai, India, April 6, 2023.
| Photo Credit: Reuters

The story so far: On August 18, apex banking regulator the Reserve Bank of India (RBI) issued guidelines enabling a borrower to transition from a floating interest rate-based loan to one with a fixed interest rate.

According to RBI, the endeavour was to address borrowers’ grievances pertaining to elongation of loan tenure and/or increase in the EMI amount in the event of an increase in the benchmark interest rate. A lack of proper communication along with the absence of consent too formed part of the concerns.

The provisions would be extended to existing as well as new loans by the end of the current calendar year. 

What exactly has the RBI instructed?  

As stated above, the apex banking regulator has given borrowers the option to switch over to a fixed (interest) rate mechanism for their loans from floating rates. This would be based on a board-approved policy drafted by the lending entity. The policy must also specify the number of times such a switch would be allowing during the tenure.

The lender must also transparently communicate to the borrower all relevant charges alongside service charges or administrative costs associated with the transition. 

The responsibility would rest with the lender to communicate clearly, at the time of loan sanction, the impact emanating from the change in regime (floating to fixed), such as the change in EMI and/or tenure of the loan or both. Additionally, the borrower would now also have the option to choose between enhancement of the EMI or elongation of the tenure or a combination of both. S/he might also opt to prepay the loan, either in part or full, at any point during the tenure. This would, however, still invite foreclosure charges or pre-payment penalty.

 Further, the regulator has sought that lending entities provide borrowers, through appropriate channels, a statement at the end of each quarter enumerating the principal and interest recovered till date, EMI amount, number of EMIs left and annualised rate of interest/ Annual Percentage Rate (APR) — for the entire tenure of the loan. RBI has asked for the statement to be “simple and easily understood by the borrower”. 

The instructions would apply to all equated instalment-based loans of different periodicities. albeit with certain changes based on the nature of the loan. 

What is the difference between a fixed and floating interest rate?  

Fixed interest rates are those that do not change during the tenure of the loan. On the other hand, floating interest rates are subject to market dynamics and the base rate — therefore, the risk differentiation. As also contended by several lending entities, floating interest rates are generally lower than the fixed interest rates. For example, if the floating interest rates for home loans is 10.5%, the fixed interest rate would be 12%. 

Lenders argue that even if the floating interest rate were to rise by up to 2.5 percentage points, the borrower would be able to save more money when it is below the fixed rate. It has been widely argued that their preference for the floating rate-based regime is to better adjust their positions as per the evolving market dynamics. Should the benchmark rates drop significantly, the advantages are transmitted onto the borrower’s savings pool, but the opposite also holds true in a rising benchmark rate regime. Also noteworthy is the fact that floating interest rate loans do not draw any prepayment penalty— unlike fixed rate loans. 

However, the fixed rate-based regime endows a borrower with greater certainty and security. This also helps in better planning and structuring of individual budgets.

Thus, prospective borrowers should note broader evolving economic dynamics and accordingly decide the tenure they seek. 

In a largely similar context, in 2010, V.K. Sharma, then Executive Director at the RBI, said at a conclave that lenders may argue that housing loan borrowers would prefer a floating-rate loan to a fixed rate. This is where RBI’s guidelines relating to “customer appropriateness and financial literacy and credit counselling” enjoined upon banks come in, he pointed out.

“This is because typically an unsophisticated, and uninitiated, borrower may be driven largely by the prevailing lower short-term interest rates, almost completely oblivious to the potentially higher interest rates over such a long-time horizon, as say, 10 years or more,” he stated. 

What does the regular state about assessment of repayment capacity?  

RBI stated in the circular that lending entities are required to consider the repayment capacity of the prospective borrower. This is to allow borrowers adequate (or optimum) headroom/margin for elongation of tenure and/or increase in EMI.  

About parameters for assessment, Governor Shaktikanta Das, too, had earlier stated that banks would have to consider the payment capacity of the borrower and how longpayment capacity would last (the age factor). He cautioned that it would be necessary to “avoid unduly long elongation which sometime may going forward camouflage the underlying stress in a particular loan.” The extension, he stated, must be for a “reasonable period”. 

“It is a commercial decision that the banks have to take. We are just providing some broad guidelines,” he informed.