By all accounts, the US Federal Reserve policy was hawkish on Wednesday. Yet, shares rose and bond yields inched up marginally by 2 basis points on the 10-year. Experts told CNBC-TV18 that this is because despite a very hawkish increase in inflation forecasts, the Fed’s dot chart indicates that the number of expected rate hikes have only gone up from 6 to 7 by 2024. The market, therefore, assesses that while the Fed is worried about inflation, it stays accommodative and won't chase up rates to chase down inflation.
Let us start with the key takeaways from the FOMC statement: it said it would stop bond purchases three months earlier. It also forecast 2022 inflation to be 40 basis points higher than its earlier forecast, i.e., at 2.6% versus 2.2% earlier. The Fed also advanced its rate hikes to three in 2022, versus one or none indicated earlier. And finally, it dropped the word “transitory” to describe inflation.
| Now | September |
| Bond buy cuts per month | $30 bn | $15 bn |
| Bond buys drop to zero by | March | June |
| Rate hikes in 2022 | 3 | 1 |
| Rate hikes in 2023 | 2 | 3 |
| Rate hikes in 2024 | 2 | 2 |
| All items’ inflation estimated for 2021 | 5.3% | 4.2% |
| Core inflation in 2021 | 4.4% | 3.7% |
| All items’ inflation estimated for 2022 | 2.6% | 2.2% |
Indeed, in the press conference, chairman Jerome Powell said, “What we need is another long expansion; that's what it would really take to get back to the kind of labour market that we'd like to see and to have that happen we need to make sure that we maintain price stability." That statement almost means the Fed sees current high inflation as a threat to growth
But that’s not how the markets received the FOMC statement or the press conference statements. Quite the contrary. Chetan Ahya, chief Asia economist at Morgan Stanley, said “the more interesting point that I saw the markets observed, is that the fact that they have raised their inflation forecast for 2022 to 2.7 from 2.3. And if you look at inflation expectations--at the break-even inflation expectations priced in by the bond market--they moved up by 5.5 basis points. And correspondingly, the 10-year real rates actually declined. And now they're at about 100 basis points.” Ahya’s point is that for a 40 basis-point rise in inflation forecasts, the rates forecast over the next three years have only gone up from 6 to 7 hikes. The real rate or the inflation breakeven rates (which is nominal rates minus inflation) thus actually falls, and that explains the muted reaction in the bond markets. Stocks correctly read that the Fed is not increasing rates commensurate with the hike in its inflation forecast.
Steve Englander, MD at Standard Chartered, echoed Chetan Ahya’s observation: “As Chetan said, what I found very interesting is that they took their 2022 inflation forecast to 2.6, core inflation to 2.7. But the response was to add one hike, relative to where they were in November. I think what the market took away was that it is a very calm response to inflation, no tearing the hair out and wringing their hands, but kind of saying, 'we can deal with this, and inflation will come down.' So it was reassuring to the market.”
This explains the market response: weaker dollar, which is correlated with improved risk appetite, stronger US equities.
For emerging markets in Asia, Ahya said, "The Fed’s benign increase in rates is good news. In any case, Asian inflation is not surging as much as US inflation. With the very slight rise in US yields, and actually a fall in real yields, the relative differentials between Asian real rates and US real rates are at a high." He added: ”Asia doesn't have to be sort of under pressure to follow through; also, Asia's other macro stability indicators in form of inflation and current account balance are in pretty good shape.”
The Fed’s not-so-aggressive rate-hike response to its rather aggressive rise in inflation forecasts also means a positive stance for growth, like in 2004-2007. Ahya said, ”In that cycle, the Fed kept real policy rates close to zero until the end of 2005. And correspondingly, for the first 12 months since the Fed started to hike, real 10-year rates remained flat. And we are seeing something similar right now, in terms of the real policy rates, as well as the real 10-year bond markets.”
Consequently, Morgan Stanley expects growth conditions to be very strong in the US, with GDP growth at around 4.5% in 2022 as it expects monetary policy to stay accommodative even while the Fed hikes rates. Also, even if the US fiscal deficit is going to go down, the government has already done fiscal transfers in the past two years which is still sitting in households' balance sheets and will ensure strong demand
Englander also points out that by mid-2022, growth will look less strong and inflation too will be a lot weaker than it is today, so there are chances of the Fed sounding dovish, which can weaken the US dollar. A weak dollar usually abets a rally in risk assets like equities.
Short point: After a supposedly hawkish Fed policy, the verdict of economists and of the markets is that the Fed’s monetary policy will remain accommodative and hence, supportive of economic growth and risk assets.
(Edited by : Vijay Anand)
First Published: Dec 16, 2021 7:49 PM IST
