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Fed statement hints at quicker taper and early rate hikes

The message from the Fed Chair, Jerome Powell, was crystal clear. Despite the risk of the Omicron virus, the Fed was willing to get out the hosepipes to douse the fire of inflation. After all, with inflation at 6.8% in November 2021, the Fed had little choice other than to expedite tapering of liquidity.

December 16, 2021 9:12 IST | India Infoline News Service
The Federal Open Markets Committee (FOMC) concluded its all-important meet on December 15th. The message from the Fed Chair, Jerome Powell, was crystal clear. Despite the risk of the Omicron virus, the Fed was willing to get out the hosepipes to douse the fire of inflation. After all, with inflation at 6.8% in November 2021, the Fed had little choice other than to expedite tapering of liquidity.

On Wednesday, the US treasury yields moved up, stocks moved up, the dollar strengthened and gold was tentative. In a radical shift, the Fed announced plans to accelerate the bond buying cut from $15 billion per month to $30 billion per month. Here is a summary.

Details October 2021 November 2021 December 2021 January 2022
Bond Buying $120 billion $105 billion $90 billion $60 billion

In short, if you go by this latest trend, the Fed should bring bond buying down to zero by March 2022 and probably start rate hikes immediately after that. First the CME Fedwatch.

CME Fedwatch gives sharply hawkish signals

One indicator of the probability of rate hike and its timing is CME Fedwatch. Here are the implied probability of different Fed rate scenarios over the next 9 Fed meetings.

Fed Meet 0-25 25-50 50-75 75-100 100-125 125-150 150-175 175-200
Jan-22 95.0% 5.0% Nil Nil Nil Nil Nil Nil
Mar-22 54.5% 43.4% 2.1% Nil Nil Nil Nil Nil
May-22 35.2% 47.3% 16.7% 0.7% Nil Nil Nil Nil
Jun-22 15.6% 40.6% 33.8% 9.7% 0.4% Nil Nil Nil
Jul-22 10.4% 32.2% 36.0% 17.7% 3.5% 0.1% Nil Nil
Sep-22 6.3% 23.7% 34.6% 24.9% 9.0% 1.4% 0.1% Nil
Nov-22 4.6% 19.0% 31.6% 27.5% 13.3% 3.5% 0.4% Nil
Dec-22 2.0% 10.8% 24.4% 29.9% 21.4% 9.1% 2.2% 0.3%
Feb-23 1.5% 8.7% 21.2% 28.6% 23.4% 12.1% 3.8% 0.8%
Data source: CME Fedwatch

Normally a probability in the range of 25% to 30% is indicative of a strong possibility of an event. If you compare the latest table above with the similar probabilities on the date of the last Fed minutes announced on 24-Nov, some clear shifts are visible.

a) The probabilities have sharply shifted towards more hawkishness across the next 9 Fed meetings with higher rates being accorded higher probabilities. This is after the aggressively hawkish tone adopted by Jerome Powell.

b) On 24-Nov the Fedwatch hinted at high probability of the first rate by Mar-22 and a total of 4 rate hikes by Dec-22. As per the latest Fedwatch data, the outer limit remains the same but there is hint of bunching 3 rate hikes by Jul-22 itself.

c) With the taper now likely to get completed by Mar-22 instead of Jun-22, it is clear that the Fed is not taking chances with 6.8% inflation. As inflation pinches harder than imagined, rate hikes are set to happen quicker, with larger implications.

Key takeaways from the Dec-21 FOMC Statement

Here are 7 key takeaways from the Dec-21 FOMC statement.
  1. The taper timetable has become a lot more aggressive. The monthly bond buying reduction will go up from $15 billion to $30 billion from Jan-22, effectively completing the taper program by the end of Mar-22. This opens the doors for two or more rate  hikes to be pushed through by September 2022.
  2. Unlike the normal Fed statements, the virus threat and economic stability have got more of a passing reference with the primary focus being entirely on bringing down inflation to more manageable levels. The US Inflation at 6.8% for Nov-21 is reminiscent of the early days of the Paul Volcker era and is a 39-year record.
  3. Powell, normally a dove at heart, has given two key reasons for the urgency to complete the taper and embark on rate hikes. Of course, the high levels of inflation is a major issue but Powell also dwelt at length on the risk of asset valuations. Powell underlined that a hawkish policy was the key to prevent a speculative bubble.
  4. Transitory inflation is not a workable concept any longer, at least not with the retail inflation at 6.8%. The Fed statement has dropped the adjective “transitory” to describe inflation and instead used the word “elevated”. It hints that the current inflation problem is not going away in a hurry without stringent and rapid tightening.
  5. In a significant shift, Fed has underlined in its statement that Omicron would not derail the commitment of the Fed to accelerate the taper nor its endeavour to trigger rate hikes in the first half of 2022. That is a hawkish indication enough. Powell underlined that even if Omicron worsens, it would be less of an economic challenge.
  6. On the subject of jobs recovery, Powell has admitted that this time around the labour recovery had not been as impressive as the recovery in the macroeconomy. However, that could be more because jobs are getting less labour intensive. Hence, the Fed is going by improvement in labour participation rather than total return to normalcy.
  7. In one of the most telling revelations, Powell noted that due to the strong economy, there was no need for a long lag between completion of taper and rate hikes. That is perhaps the biggest indication that rate hikes may not wait too long.
Takeaways from the Fed statement for Indian economy

For the Indian economy there are 3 key takeaways.
  • Early taper and early rate hikes by the US are not a debate any longer. They are round the corner and India must have a back-up plan to handle the risk-off flows that would arise as a consequence of this action.
  • Too much liquidity, too much speculation and an asset bubble are challenges for the Indian economy too. This underlines the need for the RBI to move fast on shifting out of its accommodative monetary stance.
  • The big challenge will be handling the short-term volatility in the equity and money markets, which are extremely sensitive to Fed shifts. That is already evident in the FPI outflows and the rupee weakness.
The Fed policy statement on 15-December would drive a greater sense of urgency into Indian monetary policy. Hawkishness is not a choice any longer!

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