Fed review of the economic situation
The broad takeaways from the Fed minutes can be summarized as under.
- Fed pointed out that the pandemic outbreak and the lockdown had severely disrupted economic activity; both in the US and abroad
- The US labour market conditions deteriorated substantially in March and April with unemployment close to 15%; the highest since the Second World War
- Real GDP declined sharply in the first quarter and an array of indicators were pointing toward an extraordinary contraction of GDP in Q2
- Consumer price inflation measured by the 12‑month change in price index for personal consumption expenditures (PCE), remained below 2% due to weak demand
- The US corporate credit markets had major concerns over potential defaults and ratings agencies had put on negative watch or downgraded many issuers
- The likelihood of mortgage delinquencies in the US had sharply escalated becoming a major source of concern for bank and nonbank lenders.
- With respect to emerging markets, the steep decline in commodity prices was aggravating the financial pressures for some emerging market economies
- Most emerging markets were facing a combination of risk-off capital outflows and weak exports leading to a free fall in most currencies versus the US dollar
What it means for US Fed policy action?
While the US may have limited policy choices, here is the likely trajectory of policy action by the US Fed.
- The Fed rates, which were cut to the lowest possible level of 0.00-0.25% in late March, are likely to be held at that level for now. The Fed has not yet seriously given a through to the possibility of negative rates (unlike Europe and Japan).
- In terms of immediate policy action, the Fed may define a minimum time period during which the Fed rates will not be moved above the current level of 0.00-0.25%. This would give more policy stability in terms of rates.
- In terms of growth drivers, the Fed has expressed concerns over a second wave of Coronavirus infections in the US. According to the Fed, such a spike would negatively impact recruitment of workers as also capital expenditure plans.
- The Fed also indicated that the liquidity infusion in terms of asset purchases would continue, albeit at a slower rate. While outside the ambit of Fed, they also hinted at a mix of fiscal measures to prop up growth.
- Fed also hinted at yield curve management. One of the concerns for the Fed was the inverted yield curve with 2-year yields above 5-year yields. Fed was likely to use a combination of liquidity and rates to smoothen the curve.
The Fed minutes could have multiple implications for the Indian economy in general and the monetary stance in particular.
- If the US Fed holds rates in the range of 0.00-0.25% with a time-bound assurance, it makes policy action a lot simpler for RBI. There were some doubts raised when the RBI cut rates by 75 bps ahead of the previous policy. The latest minutes of the Fed should give comfort to the RBI that US rates are likely to remain dovish.
- The Indian bond markets have seen heavy FII selling in the months of March, April and May. The rate trajectory of the Fed will reassure the fund managers that the attractive yield spread on Indian debt paper is likely to sustain in the near future.
- Indian equity markets have largely been a function of liquidity flows and the unlimited liquidity check-books of the Fed will ensure global liquidity remains robust. That has normally provided the impetus to Indian markets.
- Lastly, there are some positives for the IT and pharma sectors. Pharma sector will gain from a more accommodative pharma policy as the COVID-19 impact is likely to linger for some time. The direct support to business by the US Fed will ensure that the damage to IT spending is limited. That will benefit India IT stocks. Above all, the affirmative policy action by the US will keep the US Dollar strong. That would be positive for key export oriented sectors.