The market reaction to Fed minutes was almost immediate. The NASDAQ index sank over 3% and has lost nearly 8% in the last 1 week. At the same time, the 10-year benchmark rate in the US surged to 1.73%. The Fed meeting held on 15-16 December had already hinted at front-ending the total taper by end of March 2022 and start rate hikes much sooner. One of the best ways to summarize the minutes of the Fed meet is through the DOT plot chart.
What does the DOT Plot chart tell us about US Fed policy?
The DOT Plot chart is a frequency distribution of expectations of the members of the FOMC, as to where they see the Fed rates at the end of each year for the next 4 years. The chart below shows the DOT Plots.
Here is how you read the above DOT Plot chart of the Fed
a) The green line represents what the FOMC members on an average expect the Fed funds to be. This is like a frequency distribution chart so the relevant number is where you see the dots clustering.
b) As you can see from the above chart, the expectation is around 1% by end of 2022, 1.75% by end of 2023 and 2.25% by end of 2024. Long term rates are expected to stabilize at around 2.5%.
c) The white line is the more dynamic line which crosses verifies the Fed Dot Plot with what the Fed Fund futures are indicating. The Fed Fund Futures chart is diverging lower as it is factoring in the limits to hawkishness if Omicron deepens.
For the immediate future, the DOT plot indicates that rates would most likely increase by 75 bps from the current 0.00-0.25% to a level of 0.75-1.00% by end of 2022.
Key takeaways from the minute of the Dec-21 Fed meet?
The DOT plot is the front end of the FOMC member perception, but more important are the discussions that happen at the back-end. That is captured in the minutes.
• The consensus appears to be that, irrespective of Omicron vulnerabilities, the Fed would go ahead aggressively with the taper. In fact, the plan was to complete the entire taper by the end of March 2022. The minutes indicate that the Fed is open to concluding the taper even before March if the glut of liquidity continued to pose problems for the financial system.
• The second major concern was the rising inflation number. It has now settled above the 6% mark and in November, the inflation had scaled 6.2%. That is the highest level of inflation seen since the Paul Volcker era in the early 1980s and the monthly inflation is the highest in nearly 4 decades. That has created a solid case for giving greater emphasis to inflation control than to wait for balanced revival in growth.
• The minutes were also a lot more aggressive about the timing of the rate hikes and the quantum of rate hikes. Let us look at both the items separately. Regarding the timing of rate hikes, the Fed had originally maintained that rate hikes would start a year after completion of taper. In the Dec-21 policy, Fed suggested that rate hikes could start much earlier. The minutes indicate that Fed is open to start rate hikes from Mar-22.
• A quick glance at the DOT plot chat shows a median expectation of a 75 bps hike this calendar year 2022 to the range of 0.75% to 1.00%. However, what is apparent in the minutes of the meeting is that if inflation continues to remain persistently high, Fed would not hesitate to front-end rate hikes even further.
• In all previous taper discussions, the focus was purely on the additional $120 billion of monthly taper. There was little talk about the existing $9 trillion of bonds that the Fed holds in its balance sheet; something gradually built since GFC-2008. The minutes indicate that the Fed is open to starting the balance sheet unwinding in 2022 itself.
• The CME Fedwatch indicator hints that the first rate hike by the Fed could happen as early as March 2022, once the taper of fresh buying is fully done. Immediately after that, the minutes are hinting at a massive winding down of the US Fed balance sheet starting off. Clearly, the Fed sounded much more hawkish than it ever sounded since 2008.
• The Fed statement on 16-December dropped reference to “Transitory” inflation for the first time. The minutes of the meeting have only underlined this shift.
For now it looks like the Fed is ready to live with the market volatility that may arise as a result of the taper, rate hikes and portfolio unwinding.
What policy options does this leave RBI with?
The RBI policy in Feb-22 will be a lot more critical as by then the US Fed would have demonstrated its sense of urgency on taper. There are 3 options for the RBI.
• For now, the lending rates and benchmark bond yields in India are out of sync with the repo rates. Some rate hike is called for to bridge this gap between policy and market expectations.
• For India, it will not be so much about rates, but handling the shutting of liquidity taps. Fed is not only talking about hurrying through the taper but also a mega unwinding of its $9 billion balance sheet.
• The need of the hour for the RBI is solid financial buffers. If India’s trade deficit and fiscal deficit continue at elevated levels when the Fed is tightening aggressively, that is like asking for trouble.
For the RBI, the Feb-22 policy may be the time to take some real hard decisions.