At the time of the Fed policy announcement on 28 April, there was an 88% probability of status quo and 12% probability of 25 basis points rate hike. After the minutes on 19 May, the probability of status quo has actually gone up to 90% and probability of 25 bps rate hike is down to 10%. What explains this situation where neither the current bond yields nor the expected rates appear to be going up?
It has to do with the time table of the Fed
In the takeaways of the FOMC meet announced 3 weeks back, the Fed had underlined that even if the view was to turn bullish, the waterfall of priorities would be to first taper the bond buying program. Only if that was insufficient, the rate hike instrument would be used. In fact, the Fed even offered an approximate time table.
The indication was that, in a worst case scenario, if inflation went through the roof due to growth impuses and spurt in consumption, Fed would first try and cool the economy by tapering bond purchases. This would automatically regulate the liquidity flow in the system. That is expected to happen only towards the end of 2021, if necessary. However, the Fed also indicated that even if rate hikes became inevitable, any rate hike was unlikely before the end of calendar 2022. But, first the takeaways of the Fed minutes!
Key takeaways from the minutes of Apr-21 FOMC Meet
While the Fed minutes have clearly given up its hard core dovish bias, it is clear that they are still averse to use the “rate hike” term. However, some of the macro realities are adequately captured in the minutes.
- Fed has used two important clauses in its statement. The minutes hinted that tapering of asset purchases might be “appropriate at some point” in the future. At least, the Fed is now officially acknowledging that tapering could begin at some point. Secondly, the Fed minutes have inserted the condition of “rapid progress” in economic growth. Hence, it is not just growth but rapid growth that will be a trigger.
- The discussion on inflation was largely missing from the Fed minutes. Apparently, the Fed is looking at the recent spike in US retail inflation to 4.2%, more as a temporary phenomenon in reponse to supply chain constraints.
- Most of the Fed members appeared to hint that tightening of monetary policy may be warranted if economic activity picked up. However, the policy response mechanism is not too vivid. It does appear that the Fed may first taper part of the $120 billion of monthly bond purchases and then look at rate hikes, if necessary.
- The apprehensions that Fed may have to taper bond purchases sooner is not entirely misplaced. The Fed balance sheet now stands at $7.90 trillion, which is twice the balance sheet of the Fed since the COVID pandemic began. In fact, the Fed has now reached a stage where it is increasingly buying private debt rather than treasury debt.
- Fed minutes are, however, emphatic that any policy shift was unlikely until the economic goals of employment and inflation were triggered on a sustainable basis. For the first time, Fed minutes have spoken of a stop-gap response and a longer-term policy reponse to the emerging situation.
- Chairman Jerome Powell, underlined that the economic recovery was still too uneven to merit a policy response. For example, GDP jumped to 10% and inflation to 4.2% but non-farm payrolls have risen by just 266,000 against target of 1,000,000. That, according to Powell, is still an uneven overall recovery.
The mood of global markets in general and Indian markets in particular, post Fed minutes, was captured by a forex trader. “In the current context, Fed not doing anything is positive. Also, the Fed not talking hawkish is akin to talking dovish.” Fed action matters for India because Indian markets are still largely driven by liquidity and both the taper and rate hikes are likely to tighten liquidity flows into India.
One thing is clear from the Fed minutes. US economic growth may be optically high due to a low base and inflation may be optically high due to supply chain constraints. The Fed will not take any action, unless they get to see normalized data on this front. The good news is that, such normalization could still be some time away!