US Fed hints at rate hikes, earlier than anticipated

For the first time since the onset of the pandemic, Fed indicated that monetary looseness may start unwind, sooner than anticipated. In terms of specifics, Fed has hinted at 2 rate hikes of 25 bps each by the end of 2023.

Jun 17, 2021 08:06 IST India Infoline News Service

The much anticipated Fed policy on 16 June did almost all that was expected. It reiterated the need to keep monetary policy accommodative and rates low. The policy also underlined that growth and inflation impulses were picking up. Above all, there was one big shift in the language of the Fed.

For the first time since the onset of the pandemic, Fed indicated that monetary looseness may start unwind, sooner than anticipated. In terms of specifics, Fed has hinted at 2 rate hikes of 25 bps each by the end of 2023. That is still a good 2 years away, but markets surmise that, push comes to shove, Fed may not hesitate to hike rates earlier.

CME Fedwatch  - Look at the Dot Plot chart

Chart Source: CME Fed Watch

In a significant statement like the 16-Jun policy, traditional CME Fedwatch probabilities do not give the precise picture. It only assigns probabilities for the remaining three FOMC policies in 2021. Post the FOMC meet, the CME Fedwatch has assigned 100% probability to status quo till end of 2021. It, therefore, calls for a longer term perspective.

The Dot-Plot chart above, captures the median projections of all FOMC members. There are three things one can infer. Firstly, while Fed has given time limit of 2023, members expect rate hikes to start in 2022 itself if GDP growth and inflation sustain above median levels. Secondly, for year 2023, median expectation is 50 bps rate hike but aggressive estimates are factoring up to 100 bps. Lastly, long-term Fed rate is being projected at a median of around 2.5%, which is well below pre-crisis levels.

Five noteworthy points made by the FOMC

If you go by the initial reaction of the Dow and benchmark bond yields, markets started factoring higher rates. This is likely to have a spill-off effect across global markets. Here are 5 key takeaways from the FOMC statement.
  1. For the first time, the Federal Open Market Committee (FOMC) actually signalled that the median benchmark rate could be lifted from near 0% levels currently to around 0.60% by the end of 2023. However, the timetable will be data driven.
  2. While rate hikes would happen over a period of time, Fed indicated that gradual tapering of the Fed bond buying program could commence anytime in next 2 years. Currently, the US Fed is infusing $120 billion monthly; $80 billion into government treasuries and $40 billion into mortgage backed securities.
  3. The official FOMC statement pointed at 3 crucial factors driving the change of stance by the FOMC. Firstly, rapid progress on vaccinations had curtailed the spread of COVID-19 in the US, offering a lifeline to the GDP recovery. Secondly, high frequency indicators are hinting at GDP growth, consumer spending and inflation rising to median levels desired by the Fed. However, the Fed underlined that while job creation had strengthened, it was way below the ideal full employment scenario.
  4. Meanwhile, Fed has assured to continue bond purchases until substantial progress was made in the recovery. Fed reiterated that it would look at recovery after offsetting the impact of revenge consumption, supply driven inflation and low-base triggered growth. It reassures markets that any sudden tapering was unlikely for now.
  5. On the jobs front, Jerome Powell emphasised that job creation had slowed to 837,000 in April and May. Total employment was still 7.6 million short of pre-pandemic levels. May-21 inflation was at 5% but Fed would focus on inflation adjusted for supply-chain issues.
In a nutshell, the Fed will prefer to wait for unemployment to fall from the current 5.8% to around 4.5% and long-term inflation to sustain above 2%. If this combined with sustainable GDP growth of over 4% with broad-based economic recovery, the Fed would have a strong case for a tapering and a rate hike. But that would be some time away.

What the Fed statement means for India?

The good news is that the US economy is growing. That is always the best bellwether for the Indian economy since the India story is directly and indirectly predicated on US robustness. Secondly, the broad hint of 2 rate hikes by end-2023 will be data driven. It assumes that the situation gets progressively better for the US and world economy. For Indian capital markets, it is the liquidity that is material and that is likely to remain strong as long as the US does not embark on aggressive tapering. There are no such signals for now.

Logically, as growth picks up, the US Fed would look to raise the Fed rates and taper the bond buying. However, there is a difference this time around. Biden is planning a trillion dollar investment to boost infrastructure and that would be funded largely by the capital markets. That pre-supposes abundant supply of liquidity and competitively low rates of interest. The moral of the story for India is that neither rates, nor liquidity is likely to change substantively in the near future.

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