The weaker-than-expected US economic growth in the first quarter will unlikely detour the Federal Reserve from raising interest rates by 25 basis points next week as it is widely expected that the central bank will press brakes on tightening policy after May due to rising probability of a US recession later this year.
The central bank policymakers anticipate a modest recession to begin later this year, followed by a recovery over the following two years, according to the minutes of the March 21-22 policy meeting, the ongoing banking sector stress have encouraged markets to price-in at least a 25 basis point rate cut by the end of this year.
Still, the biggest challenge for the central bank is inflation which remains stubbornly high for now. This, coupled with the banking crisis could push the US economy to a recessionary environment much sooner than anticipated, according the economists.
Best Case Scenario
If the Fed raises rates, inflation cools-off substantially and labour market remains robust while the US economy stabilizes, that will be best for the world’s largest democracy.
While these are very optimistic calls considering inflation is far from the central bank’s target, the banking turmoil adds further worries.
Still US Primary Deal Goldman Sachs expects the Fed to hike by 25 bps in May and June to end at a terminal rate of 5.25%-5.50%, which is above both market pricing and FOMC forecasts.
“We believe stress in the financial sector has moderately tightened credit conditions, potentially substituting for one or two Fed policy rate hikes,” say economists at Goldman.
Those forecasts are more or less in-line with money market expectations of one definite hike in the May 2-3 meeting taking the fed funds rate to 5.00-5.25% - highest since 2006.
Worst Case Scenario
The prospect of the Fed raising its interest rate only once more and in a 25 basis point increment is a useful starting point but the central bank's policy path will depend on incoming data, New York Fed President John Williams said on Tuesday.
While central banks’ decisions are always data dependent, if the inflation doesn’t subside, with slowing economy, the Fed could face challenges in stabilizing the economy in the middle of a banking crisis.
“Fed has other tools to deal with banking crisis, monetary policy will be the last option for the Fed to tackle the Banking crisis, says Dan Fineman of Credit Suisse.
If the labour market stays resilient and inflation stays persistent the Fed may have to keep raising rates for longer despite the US economy losing momentum in the middle of a banking turmoil.
While inflation in the US have cooled-off a bit it is still a few fold over the Fed’s target band of 2 percent.
Mohamed A. El-Erian, former CEO and co-CIO of PIMCO tweeted recently.
India Impact Of Fed Rate Hikes
Conventionally, a raise in US interest rates makes US assets more attractive and investors usually sell their investments in emerging markets and buy US assets. So, that increases the pace of foreign outflows and add to the rupee’s woes.
For Indian companies, the rate hike and fund reduction are likely to impact the availability and cost of overseas finance. Foreign portfolio flows into the Indian equity and bond markets could slow.
But May rate hike is broadly priced in and Indian market will possibly not react much unless there is a big surprise from the US central bank.
“It is clear That Fed will be raising rates atleast one more time, services are holding up well, see some signs of softening on the edges, says Gary Schlossberg, Global Strategist at Wells Fargo.
“We are close to a peak when it comes to long-term rates, India will benefit as inflation has subsided.”
India is a domestic demand driven economy but there are some vulnerable spots which may get hurt by high interest rates or a recession in the US or Europe, for e.g. exports.
But 0.25 percent rise in US interest rates will probably have only minimal impact on exports.
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