While there has been a lot of hawkishness in the wordings of the FOMC policy statement, the tone of the minutes were a lot more subdued. In addition, the developments on the Ukraine front and the spike in oil prices hint at new macro challenges for the world economy in general. It is in this light that the Powell testimony assumed a lot of importance.
The testimony of the chairperson of the Federal Reserve is part of the routine process after each FOMC meeting. Normally, the FOMC meeting is followed by the publication of the minutes after 21 days. A week later, the Fed chair testifies before the US House of Representatives, Financial Services Committee. Normally, this testimony contains important cues as it factors in the post-FOMC meet developments and also fields questions.
What Powell testified before the Financial Services Committee?
The broad thrust of the Powell testimony was that the Fed would stick to the stance of its monetary policy. However, Powell also admitted that the Russian aggression on Ukraine had opened up a new set of variables in global economics.
Here are the key takeaways.
a) Powell underlined that despite the ongoing stand-off between Russia and Ukraine, the impact on the US macros were still limited. The Ukraine remained an X-factor but Powell was convinced that it would not affect the rate hike trajectory of the Fed.
b) However, there has been a toning down of rate hike expectations in the forthcoming FOMC meeting scheduled on 16th March. Instead of the 50 bps hike originally intended, Powell has confirmed that the rate hike may be restricted to just 25 bps in March.
c) More than anything else, Powell underlined the need to remain nimble and fleet footed with respect to handling the current situation. Powell testified that it would be tough to get stuck to any kind of long term position in this volatile geopolitical situation.
d) Underlining the need to start the rate hike process quickly, Powell highlighted in his testimony that the current consumer inflation at 7.5% was way above the 2% inflation target. That has meant a huge negative gap between bond yields and inflation.
e) However, Powell has also testified to the house about the need to proceed carefully in the highly uncertain environment as the situation could get complicated if the Fed got too hawkish at a time when supply constraints start hitting growth once again.
f) Powell highlighted that if inflation, labour markets and GDP growth were the 3 dimensions of the monetary policy of the Fed in the past, the last few weeks had added the fourth dimension of the Ukraine war. Powell was of the view that since inflation was no longer transitory, normalization of war situation could result in more aggressive rate hikes by the Fed post the March policy.
g) On the subject of inflation, Powell held on to the Fed view that inflation should taper in the coming months. However, he underlined that if and only if inflation did not taper, Fed would consider being more aggressive on rate hikes. Broadly, this may be interpreted that the Fed would end up being less aggressive than what hawkish investment managers like Goldman Sachs had projected about rate hikes in 2022.
h) Normally, there is a disconnect between the Fed minutes and dot plot charts on one side and the market estimates of rate hikes as depicted by the CME Fedwatch. The disconnect is explained in the Fed Chair testimony. On the one side, Powell underlined that inflation at 3 times the 2% target was unsustainable. However, the testimony has use an interesting term “keeping options open”, which actually throws up a whole range of possibilities on how the Fed will move in the coming months.
i) In a way, the situation in Europe had created two extreme possibilities for the Federal Reserve. On the one hand, the spike in the price of oil and minerals had the potential to push inflation higher creating a base case for raising rates. At the same time, the Ukraine crisis also had the potential to stymie GDP growth due to weak global demand and supply chain constraints. The Fed gas to identify the reality between the extremes.
j) On the subject of winding down the balance sheet, Powell underscored that the Fed was committed to downsize the balance sheet, which could start after March once the first rate hike was implemented. However, here again, there is a dilemma. For instance, if the current situation in Ukraine was to widen into a larger conflict, the Fed could be called upon to engender stability in the dollar markets. This could again expand the balance sheet of the Fed instead of shrinking the size of the Fed asset holdings.
In short, the comments by Powell highlight the tightrope walk that the Fed needs to do. If the high inflation level made a call for rate hikes, then the demand damage caused by the war could call for a dovish policy. Similarly, if the size of the balance sheet called for winding it down, then interventions in the dollar market by the Fed to create stability could result in expansion of the Fed balance sheet. The truth will finally emerge as a compromise between too much optimism and too much despondency.
What does the Powell testimony mean for India?
For the Indian markets, there are 3 positive takeaways from the Jerome Powell testimony.
• Firstly, India will be happy with a not too hawkish stance from the Fed. In the February policy, the RBI had specifically chosen to remain dovish to avoid demand damage.
• Secondly, India’s gap advantage in terms of yields will stay for now and that could stem the massive FPI outflows. It could also lead to some money coming back.
• Lastly, if the Fed is less hawkish than originally indicated and if the winding down of the balance sheet is put off for some time, then the risk-on flows are likely to come back
The Powell testimony may not give too much of comfort from a macro perspective but surely gives adequate reasons to hope for more risk-on flows. That is the good news!